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SWK Holdings Corp - Quarter Report: 2008 June (Form 10-Q)

Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2008

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File number 000-27163

 

 

Kana Software, Inc.

(Exact Name of Registrant as Specified in its Charter)

 

 

 

Delaware   77-0435679
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)

181 Constitution Drive

Menlo Park, California 94025

(Address of Principal Executive Offices)

Registrant’s Telephone Number, Including Area Code: (650) 614-8300

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  YES    ¨  NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large Accelerated Filer  ¨    Accelerated Filer  x
Non-Accelerated Filer  ¨    Smaller Reporting Company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  YES    x  NO

On July 31, 2008, 41,211,958 shares of the registrant’s Common Stock, $0.001 par value per share, were outstanding.

 

 

 


Table of Contents

Kana Software, Inc.

Form 10-Q

Quarter Ended June 30, 2008

Table of Contents

 

PART I. FINANCIAL INFORMATION

  

Item 1.

  

Financial Statements

  
  

Condensed Consolidated Balance Sheets—June 30, 2008 and December 31, 2007 (unaudited)

   3
  

Condensed Consolidated Statements of Operations—Three and Six Months Ended June 30, 2008 and 2007 (unaudited)

   4
  

Condensed Consolidated Statements of Cash Flows—Six Months Ended June 30, 2008 and 2007 (unaudited)

   5
  

Notes to the Unaudited Condensed Consolidated Financial Statements

   6

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   17

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   34

Item 4.

  

Controls and Procedures

   34

PART II. OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

   35

Item 1A.

  

Risk Factors

   35

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   35

Item 3.

  

Defaults Upon Senior Securities

   35

Item 4.

  

Submission of Matters to a Vote of Security Holders

   36

Item 5.

  

Other Information

   36

Item 6.

  

Exhibits

   37
  

Signatures

   38
  

Exhibit Index

   39
  

Certifications

  

 

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PART I. FINANCIAL INFORMATION

 

ITEM I. FINANCIAL STATEMENTS

KANA SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

     June 30,
2008
    December 31,
2007
 
     (unaudited)  

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 3,212     $ 4,306  

Accounts receivable, net of allowance of $209 and $204 at June 30, 2008 and December 31, 2007, respectively

     11,810       10,247  

Prepaid expenses and other current assets

     2,200       2,391  
                

Total current assets

     17,222       16,944  

Restricted cash, long-term

     761       771  

Property and equipment, net

     2,556       2,292  

Goodwill

     12,415       12,500  

Acquired intangible assets, net

     1,976       2,226  

Other assets

     509       667  
                

Total assets

   $ 35,439     $ 35,400  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Line of credit

   $ 1,726     $ 1,177  

Notes payable

     1,302       1,873  

Accounts payable

     3,542       2,943  

Accrued liabilities

     5,053       5,486  

Accrued restructuring

     878       1,261  

Deferred revenue

     15,605       15,825  
                

Total current liabilities

     28,106       28,565  

Deferred revenue, long-term

     221       297  

Accrued restructuring, long-term

     697       1,491  

Notes payable, long-term

     880       110  

Other long-term liabilities

     488       531  
                

Total liabilities

     30,392       30,994  
                

Commitments and contingencies (Note 6)

    

Stockholders’ equity:

    

Preferred stock, $0.001 par value; 5,000,000 shares authorized; no shares issued and outstanding

     —         —    

Common stock, $0.001 par value; 250,000,000 shares authorized; 41,211,958 and 40,910,481 shares issued and outstanding at June 30, 2008 and December 31, 2007, respectively

     41       41  

Common stock subscription

     —         949  

Additional paid-in capital

     4,319,653       4,317,582  

Accumulated other comprehensive loss

     (576 )     (311 )

Accumulated deficit

     (4,314,071 )     (4,313,855 )
                

Total stockholders’ equity

     5,047       4,406  
                

Total liabilities and stockholders’ equity

   $ 35,439     $ 35,400  
                

See accompanying notes to unaudited condensed consolidated financial statements.

 

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KANA SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2008     2007     2008     2007  
     (unaudited)     (unaudited)  

Revenues:

        

License fees

   $ 3,972     $ 3,511     $ 9,695     $ 7,127  

Services

     12,681       9,882       25,243       19,300  
                                

Total revenues

     16,653       13,393       34,938       26,427  
                                

Costs and expenses (1):

        

Cost of license fees

     146       240       558       527  

Cost of services

     5,340       3,668       10,758       6,736  

Amortization of acquired intangible assets

     125       24       250       39  

Sales and marketing

     5,028       6,660       11,272       12,853  

Research and development

     3,426       3,083       6,760       6,735  

General and administrative

     2,641       3,120       5,825       6,623  

Restructuring recovery

     —         —         (482 )     —    
                                

Total costs and expenses

     16,706       16,795       34,941       33,513  
                                

Loss from operations

     (53 )     (3,402 )     (3 )     (7,086 )

Interest and other income (expense), net

     (64 )     (87 )     (167 )     (106 )
                                

Loss before income tax expense

     (117 )     (3,489 )     (170 )     (7,192 )

Income tax expense

     (20 )     (54 )     (46 )     (101 )
                                

Net loss

   $ (137 )   $ (3,543 )   $ (216 )   $ (7,293 )
                                

Basic and diluted net loss per share

   $ (0.00 )   $ (0.10 )   $ (0.01 )   $ (0.20 )
                                

Shares used in computing basic and diluted net loss per share

     41,212       36,382       41,211       36,201  
                                

 

(1)    Stock-based compensation included in the expense line items:

      

Cost of services

   $ 82     $ 56     $ 185     $ 124  

Sales and marketing

     176       225       340       464  

Research and development

     96       72       173       141  

General and administrative

     207       290       424       784  

See accompanying notes to unaudited condensed consolidated financial statements.

 

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KANA SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Six Months Ended
June 30,
 
     2008     2007  
     (unaudited)  

Cash flows from operating activities:

    

Net loss

   $ (216 )   $ (7,293 )

Adjustments to reconcile net loss to net cash used in operating activities:

    

Depreciation

     587       503  

Amortization of acquired intangible assets

     250       39  

Stock-based compensation

     1,122       1,513  

Provision for doubtful accounts

     5       217  

Restructuring recovery

     (482 )     —    

Non-cash interest accretion

     77       63  

Changes in operating assets and liabilities:

    

Accounts receivable

     (1,389 )     (442 )

Prepaid expenses and other assets

     349       175  

Accounts payable and accrued liabilities

     50       (391 )

Accrued restructuring

     (695 )     (1,064 )

Deferred revenue

     (609 )     1,785  
                

Net cash used in operating activities

     (951 )     (4,895 )
                

Cash flows from investing activities:

    

Purchases of property and equipment

     (844 )     (683 )

Acquisition, net of cash acquired

     85       (762 )

Increase in restricted cash

     —         (8 )
                

Net cash used in investing activities

     (759 )     (1,453 )
                

Cash flows from financing activities:

    

Borrowings on line of credit, net

     2,111       4,175  

Borrowings on note payable

     —         71  

Repayments on note payable

     (1,410 )     (278 )

Net proceeds from issuances of common stock and warrants

     —         1,114  
                

Net cash provided by financing activities

     701       5,082  
                

Effect of exchange rate changes on cash and cash equivalents

     (85 )     21  
                

Net decrease in cash and cash equivalents

     (1,094 )     (1,245 )

Cash and cash equivalents at beginning of period

     4,306       5,719  
                

Cash and cash equivalents at end of period

   $ 3,212     $ 4,474  
                

Noncash activities:

    

Issuance of common stock and stock options in connection with the acquisition of eVergance

     —       $ 2,776  

See accompanying notes to unaudited condensed consolidated financial statements.

 

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NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Kana Software, Inc. and Summary of Significant Accounting Policies

Nature of Operations

Kana Software, Inc. (together with its subsidiaries, “the Company” or “KANA”) was incorporated in July 1996 in California and reincorporated in Delaware in September 1999. KANA develops, markets, sells and supports customer communications software products. The Company sells its products primarily in North America, Europe and Asia, through its direct sales force and third party integrators.

Liquidity

The Company has had negative cash flow from operating activities in each year since inception. To date, the Company has funded operations primarily through issuances of common stock and, to a lesser extent, cash acquired in acquisitions. The Company’s cash collections during any quarter are driven primarily by the amount of sales booked in the previous quarter, and the Company cannot be certain that it will meet its revenue expectations in any given period. Based on the Company’s current 2008 revenue expectations, it expects its cash and cash equivalents will be sufficient to meet working capital and capital expenditure needs through December 31, 2008. If the Company does not experience anticipated demand for its products, the Company will need to further reduce costs, or issue equity securities or draw against its available line of credit to meet its cash requirements. If adequate funds are not available on acceptable terms, the Company’s ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

Unaudited Interim Financial Information

The unaudited condensed consolidated financial statements have been prepared by KANA and reflect all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the interim financial information. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2008. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted under the rules and regulations of the Securities and Exchange Commission (“SEC”). These unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with KANA’s audited consolidated financial statements and notes included in KANA’s Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC on March 17, 2008. The year-end condensed consolidated balance sheet data was derived from the Company’s audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

Use of Estimates

The preparation of the consolidated financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, stock-based compensation, provision for doubtful accounts, fair value of acquired intangible assets and goodwill, useful lives of property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from those estimates under different assumptions or conditions.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of KANA and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Reclassification

Certain reclassifications have been made to the 2007 presentation to conform to the 2008 presentation, none of which had an effect on net loss, total assets, or total stockholders’ equity.

 

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Revenue Recognition

The Company recognizes revenues in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended.

Revenue from software license agreements is recognized when the basic criteria of software revenue recognition have been met (i.e. persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable and collection is probable). The Company uses the residual method described in AICPA SOP No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” (“SOP 98-9”), to recognize revenue when a license agreement includes one or more elements to be delivered at a future date and vendor-specific objective evidence of the fair value of all undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as license revenue. If evidence of the fair value of one or more undelivered elements does not exist, all revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.

For all sales the Company uses either a signed license agreement, a signed amendment to an existing license agreement, a signed order form, a binding purchase order where we either have a signed master license agreement or an order form signed by the Company or a signed statement of work as evidence of an arrangement.

Software delivery is primarily by electronic means. If the software or other deliverable is subject to acceptance for a specified period after the delivery, revenue is deferred until the acceptance period has expired or the acceptance provision has been met.

When licenses are sold together with consulting services, license fees are recognized upon delivery, provided that (1) the basic criteria of software revenue recognition have been met, (2) payment of the license fees is not dependent upon the performance of the consulting services and (3) the consulting services do not provide significant customization of the software products and are not essential to the functionality of the software that was delivered. The Company does not provide significant customization of its software products.

Revenue arrangements with extended payment terms are generally considered not to be fixed or determinable and, the Company generally does not recognize revenue on these arrangements until the customer payments become due and all other revenue recognition criteria have been met.

Probability of collection is based upon an assessment of the customer’s financial condition through review of their current financial statements or publicly-available credit reports. For sales to existing customers, prior payment history is also considered in assessing probability of collection. The Company is required to exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenue recognition and our results of operations.

Services revenues include revenues for consulting services, customer support, training, and enterprise on-demand. Consulting services revenues and the related cost of services are generally recognized on a time and materials basis. For consulting services contracts that have a fixed fee, the Company recognizes the license and professional consulting services revenues using either the percentage-of-completion method or the completed contract method as prescribed by AICPA SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Product-Type Contracts” (“SOP 81-1”). The Company’s consulting arrangements do not include significant customization of the software. Customer support agreements provide technical support and the right to unspecified future upgrades on an if-and-when available basis. Customer support revenues are recognized ratably over the term of the support period (generally one year). Training services revenues are recognized as the related training services are delivered. The unrecognized portion of amounts billed in advance of delivery for services is recorded as deferred revenue. Enterprise on-demand revenue is recognized in accordance with the SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition, corrected copy” (“SAB 104”). Revenues from enterprise on-demand services are recognized ratably over the term of the arrangement, while set-up fees are recognized ratably over the sum of the term of the arrangement and the term of expected renewals.

Vendor-specific objective evidence for consulting and training services are based on the price charged when an element is sold separately or, in the case of an element not yet sold separately, the price established by authorized management, if it is probable that the price, once established, will not change before market introduction. Vendor-specific objective evidence for customer support services is generally based on the price charged when an element is sold separately or the stated contractual renewal rates.

 

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Accounting for Internal-Use Software

Internal-use software costs, including fees paid to third parties to implement the software, are capitalized beginning when the Company has determined various factors are present, such as that technology exists to achieve the performance requirements, the Company has made a decision as to whether it will purchase the software or develop it internally, and the Company has authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software’s estimated useful life (generally five years) using the straight-line method.

When events or circumstances indicate the carrying value of internal-use software might not be recoverable, the Company assesses the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, if it is no longer probable that the computer software being developed will be placed in service, the asset is adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on the Company’s condensed consolidated statements of operations.

As of June 30, 2008, the Company had $824,000 of capitalized costs for internal-use software less $561,000 of accumulated amortization for a net balance of $263,000.

Stock-based Compensation

Employee stock-based compensation expense recognized under Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), in the consolidated statements of operations for the three months ended June 30, 2008 and 2007 related to stock options was $561,000 and $658,000, respectively. The estimated fair value of the Company’s stock-based awards, less expected forfeitures, is amortized over the awards’ vesting period on a straight-line basis. As a result of SFAS 123(R), the Company’s loss before income taxes and net loss for each of the three month periods ended June 30, 2008 and 2007 was increased by $561,000 and $658,000, respectively, and for the six month periods ended June 30, 2008 and 2007 was increased by $1.1 million and $1.4 million, respectively. SFAS 123(R) increased basic and diluted net loss per share by $0.01 and $0.02 for the three months ended June 30, 2008 and 2007, respectively, and by $0.03 and $0.04 for the six months ended June 30, 2008 and 2007, respectively. SFAS 123(R) did not have an impact on cash flows from operations during each of the three and six month periods ended June 30, 2008 and 2007.

In 2005 and 2006, the Company extended the vesting period of approximately 1,000,000 stock options held by four terminated employees who had agreements to provide consulting services. In October 2006, the Company extended the exercise period of approximately 211,000 vested stock options of a former employee as the result of a termination agreement. During the year ended December 31, 2006, the Company granted 57,500 stock options to four non-employees who had agreements to provide consulting services. As a result of these stock option modifications to former employees and the stock option grants to consultants, the Company recorded no non-employee stock-based compensation expense for the three months ended June 30, 2008, and recorded a credit of $15,000 to non-employee stock-based compensation expense for the three months ended June 30, 2007. The Company recorded a credit to non-employee stock-based compensation expense of $3,000 for the six months ended June 30, 2008, and recorded $103,000 of non-employee stock-based compensation expense for the six months ended June 30, 2007, allocated as follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
     2008    2007     2008     2007

Sales and marketing expense (benefit)

   $ —      $ (1 )   $ —       $ 15

General and administrative expense (benefit)

     —        (14 )     (3 )     88
                             
   $ —      $ (15 )   $ (3 )   $ 103
                             

Net Loss per Share

Basic net loss per share is computed using the weighted average number of outstanding shares of common stock. Diluted net loss per share is computed using the weighted average number of outstanding shares of common stock and, when dilutive, shares of common stock issuable upon exercise of options and warrants deemed outstanding using the treasury stock method.

For each of the three and six month periods ended June 30, 2008, outstanding stock options and warrants to purchase common stock in an aggregate of approximately 11,260,000 shares, and for each of the three and six month periods ended June 30, 2007, outstanding stock options and warrants to purchase common stock in an aggregate of approximately 13,466,000 shares, have been excluded from the calculation of diluted net loss per share as all such securities were anti-dilutive.

 

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Recent Accounting Pronouncements

In April 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing the renewal or extension assumptions used to determine the useful life of a recognized intangible asset under Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also requires expanded disclosure related to the determination of intangible asset useful lives. FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. Earlier adoption is not permitted. The Company is currently evaluating the potential impact that the adoption of FSP FAS 142-3 will have on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. FAS 161 is effective for financial statements issued for fiscal periods beginning after November 15, 2008. Earlier adoption is not permitted. The Company does not believe the adoption of SFAS 161 will have a material impact on its consolidated financial statements.

In February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”), to partially defer FASB Statement No. 157, “Fair Value Measurements” (“SFAS 157”). FSP 157-2 defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to fiscal years, and interim periods within those fiscal years, beginning after November 15, 2008. The Company is currently evaluating the impact of adopting the provisions of FSP 157-2.

In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin 51, “Consolidated Financial Statements”, to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. It requires the recognition of a non-controlling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity, and it eliminates “minority interest” accounting in results of operations with earnings attributable to non-controlling interests reported as part of consolidated earnings. SFAS 160 also establishes reporting requirements that provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. SFAS 160 is effective for fiscal periods, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS 160 will have on its financial position and results of operations.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008, and will be adopted by the Company in the first quarter of fiscal 2009. SFAS 141R is to be applied prospectively to business combinations for which the acquisition date is on or after January 1, 2009. The Company expects SFAS 141R will have an impact on its accounting for future business combinations once adopted but the effect is dependent upon the acquisitions that may be made in the future.

Note 2. Fair Value Measurement – Cash and Cash Equivalents

On January 1, 2008, the Company adopted SFAS 157 which defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. SFAS 157 applies whenever other statements require or permit assets or liabilities to be measured at fair value. SFAS 157 is effective for fiscal years beginning after November 15, 2007, except for nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis, for which application has been deferred for one year by the issuance of FSP 157-2.

 

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SFAS No. 157 includes a fair value hierarchy that is intended to increase the consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:

Level 1 - instrument valuations are obtained from real-time quotes for transactions in active exchange markets involving identical assets.

Level 2 - instrument valuations are obtained from readily-available pricing sources for comparable instruments.

Level 3 - instrument valuations are obtained without observable market values and require a high level of judgment to determine the fair value.

The following table summarizes the Company’s financial assets and liabilities measured at fair value on a recurring basis in accordance with SFAS No. 157 as of June 30, 2008 (in thousands):

 

     Balance as of
June 30, 2008
   Quoted Prices
Active Markets of
Identical Assets
(Level 1)

Assets:

     

Money market funds

   $ 85    $ 85
             

Liabilities:

   $ —      $ —  
             

At June 30, 2008, the Company had $3.2 million in cash and cash equivalents. As of June 30, 2008, the Company did not have any Level 2 or Level 3 assets or liabilities.

Note 3. Goodwill and Intangible Assets

Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the assets, which is five years. The Company reported amortization expense on purchased intangible assets of $125,000 and $24,000 for the three months ended June 30, 2008 and 2007, respectively and $250,000 and $39,000 for the six months ended June 30, 2008 and 2007, respectively. The components of goodwill and other intangible assets are as follows (in thousands):

 

     June 30,
2008
    December 31,
2007
 

Goodwill

   $ 12,415     $ 12,500  
                

Intangibles:

    

Customer relationships

   $ 2,650     $ 2,650  

Purchased technology

     14,650       14,650  

Less: accumulated amortization

     (15,324 )     (15,074 )
                

Intangibles, net

   $ 1,976     $ 2,226  
                

 

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During the three months ended June 30, 2008, goodwill was reduced by $85,000 due the collection of an account receivable that was written off prior to the acquisition of eVergance Partners LLC (“eVergance”) in June 2007. There were no additions to intangible assets during the three or six months ended June 30, 2008. The estimated future amortization expense of purchased intangible assets as of June 30, 2008 is as follows (in thousands):

 

Remainder of year ending December 31, 2008

   $ 250

Year ending December 31, 2009

     500

Year ending December 31, 2010

     500

Year ending December 31, 2011

     500

Year ending December 31, 2012

     226
      

Total

   $ 1,976
      

Note 4. Stockholders’ Equity

 

(a) Stock Compensation Plans

The Company’s 1999 Stock Incentive Plan (the “1999 Stock Incentive Plan”), as successor to the 1997 Stock Option Plan (the “1997 Stock Option Plan”), provides for shares of the Company’s common stock to be granted to employees, independent contractors, officers, and directors. Options are granted at an exercise price equivalent to the closing fair market value on the date of grant. All options are granted at the discretion of the Company’s Board of Directors and have a term not greater than 10 years from the date of grant. Options are immediately exercisable when vested and generally vest monthly over four years.

The following table summarizes activities under the equity incentive plans for the indicated periods:

 

     Options Outstanding
     Number of
Shares
    Weighted
Average
Exercise Price
   Weighted
Average
Remaining
Contractual
Term
(in years)
   Aggregate
Intrinsic Value

Balances, December 31, 2007

   9,857,786     $ 5.78      

Options cancelled and retired

   (346,911 )     8.78      

Options exercised

   (1,477 )     0.10       $ 1,905

Options granted

   602,500       1.55      
              

Balances, March 31, 2008

   10,111,898       5.43    7.42    $ 17,854

Options cancelled and retired

   (1,572,367 )     7.22      

Options exercised

   —         —         $ —  

Options granted

   176,000       1.31      
              

Balances, June 30, 2008

   8,715,531     $ 4.97    7.48    $ 14,892
              

Options vested and exerciseable and expected to be vested and exerciseable at June 30, 2008

   7,228,431     $ 5.29    7.33    $ 14,506

Options vested and exerciseable at June 30, 2008

   4,922,323     $ 5.69    6.95    $ 13,722

At June 30, 2008, the Company had 15,225,321 options available for grant under its equity incentive plans.

At June 30, 2008, the Company had $3.4 million of total unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock options that will be recognized over the weighted average remaining period of 2.5 years. This amount excludes unrecognized stock-based compensation expense that relates to non-employee stock options, which cannot be estimated prior to the measurement date.

The following table summarizes significant ranges of outstanding and exercisable options as of June 30, 2008:

 

     Options Outstanding    Options Vested and Exerciseable

Range of Exercise Prices

   Number
Outstanding
   Weighted
Average
Remaining
Contractual
Life
(in Years)
   Weighted
Average
Exercise Price
Per Share
   Number
Exerciseable
   Weighted
Average Exercise
Price Per Share

$   0.10 -     1.71

   1,248,523    7.85    $ 1.49    548,892    $ 1.57

1.73 -     2.88

   1,019,554    7.12      2.03    684,565      2.00

2.95 -     2.95

   3,235,003    7.93      2.95    2,100,676      2.95

3.00 -     3.08

   141,000    8.85      3.00    35,375      3.01

3.10 -     3.10

   1,308,272    7.78      3.10    383,950      3.10

3.13 -     4.74

   1,343,249    7.29      3.63    783,620      3.86

5.23 - 735.00

   419,930    3.01      48.75    385,245      39.64
                  

Total

   8,715,531    7.48    $ 4.97    4,922,323    $ 5.69
                  

 

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Employee stock-based compensation is calculated using the Black-Scholes option pricing model for estimating the fair value of options granted under the Company’s equity incentive plans. The weighted average assumptions that were used to calculate the grant date fair value of the Company’s employee stock option grants for the three and six months ended June 30, 2008 and 2007 were as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2008     2007     2008     2007  

Risk-free interest rate

   2.88 %   4.98 %   2.63 %   4.86 %

Expected volatility

   54 %   51 %   50 %   52 %

Expected life (in years)

   4     5     5     5  

Dividend yield

   0 %   0 %   0 %   0 %

Risk-free interest rates for the options were taken from the Daily Federal Yield Curve Rates on the grant dates for the expected life of the options as published by the Federal Reserve.

The expected volatility of the stock options was based upon historical data and other relevant factors such as the Company’s changes in historical volatility and its capital structure in addition to mean reversion.

In the analysis of expected life the Company used an approach that determines the time from grant to exercise for options that have been exercised and adjusts this number for the expected time to exercise for options that have not yet been exercised. The expected time to exercise for options that have not yet been exercised is calculated from grant as the midpoint of contractual termination of the option and the later of measurement date or vesting date. All times are weighted by number of option shares in developing the expected life assumption.

The weighted-average fair value of options granted during the three and six months ended June 30, 2008 was $0.62 and $0.67 per share, respectively.

The forfeiture rate of employee stock options for 2008 was calculated using the Company’s historical terminations data.

Note 5. Comprehensive Loss

Comprehensive loss is comprised of net loss and foreign currency translation adjustments. The total changes in comprehensive loss during the three and six month periods ended June 30, 2008 and 2007 were as follows (in thousands):

 

       Three Months Ended
June 30,
     Six Months Ended
June 30,
 
       2008      2007      2008      2007  

Net loss

     $ (137 )    $ (3,543 )    $ (216 )    $ (7,293 )

Foreign currency translation loss

       (111 )      (2 )      (265 )      (29 )
                                     

Comprehensive loss

     $ (248 )    $ (3,545 )    $ (481 )    $ (7,322 )
                                     

Note 6. Commitments and Contingencies

 

(a) Lease Obligations

The Company leases its facilities under non-cancelable operating leases with various expiration dates through January 2011. In connection with its existing leases, the Company entered into letters of credit totaling $816,000 expiring in 2008 through 2011. The Company’s letters of credit can be supported by either restricted cash or the Company’s line of credit. At June 30, 2008, the Company had $4.8 million in non-cancelable operating lease obligations offset by approximately $1.2 million of sublease income from subleases that are under contract. The future non-cancelable operating lease obligations will be paid as follows (in thousands):

 

Remainder of year ending December 31, 2008

   $ 1,330

Year ending December 31, 2009

     2,358

Year ending December 31, 2010

     1,047

Year ending December 31, 2011

     53

Year ending December 31, 2012

     —  
      

Total

   $ 4,788
      

 

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(b) Other Contractual Obligations

At June 30, 2008, the Company had other future contractual obligations requiring payments of $6.9 million. The obligations represent payments on a legal settlement, minimum payments to vendors for future royalty fees, marketing services, training services, consulting services, engineering services, and sales events. The future contractual obligations will be paid as follows (in thousands):

 

Remainder of year ending December 31, 2008

   $ 900

Year ending December 31, 2009

     803

Year ending December 31, 2010

     1,546

Year ending December 31, 2011

     1,575

Year ending December 31, 2012

     1,650

Year ending December 31, 2013

     425
      

Total

   $ 6,899
      

 

(c) Litigation

On January 24, 2007, RightNow Technologies, Inc. (“RightNow”) filed a suit against the Company and four former RightNow employees who had joined the Company in the Eighteenth Judicial District Court of Gallatin County, Montana. The suit alleges violation of certain provisions of employment agreements, misappropriation of trade secrets, as well as other claims, and seeks damages. The Company is undertaking to defend itself and the named individuals to the extent required by applicable laws. The Company believes it has meritorious defenses to these claims and intends to defend against this action vigorously.

The underwriters for the Company’s initial public offering, Goldman Sachs & Co., Lehman Bros., Hambrecht & Quist LLC, Wit Soundview Capital Corp., as well as the Company and certain current and former officers of the Company were named as defendants in federal securities class action lawsuits filed in the U.S. District Court for the Southern District of New York (the “District Court”). The cases allege violations of various securities laws by more than 300 issuers of stock, including the Company, and the underwriters for such issuers, on behalf of a class of plaintiffs who, in the case of the Company, purchased the Company’s stock between September 21, 1999 and December 6, 2000 in connection with the Company’s initial public offering. Specifically, the complaints allege that the underwriter defendants engaged in a scheme concerning sales of the Company’s and other issuers’ securities in the initial public offering and in the aftermarket. In July 2003, we decided to join a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. In April 2005, the court requested a modification to the original settlement arrangement which was approved by us. Although we believed that the plaintiffs’ claims had no merit, we had decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. The Company was a party to a global settlement with the plaintiffs that would have disposed of all claims against it with no admission of wrongdoing by the Company or any of its present or former officers or directors. The settlement agreement had been preliminarily approved by the District Court. However, while the settlement was awaiting final approval by the District Court, in December 2006, the Court of Appeals reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Court of Appeals denied the plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the District Court approved a stipulation withdrawing the proposed settlement. On August 14, 2007, the plaintiffs filed an amended complaint in the six focus cases to test the sufficiency of their class allegations. On September 27, 2007, the plaintiffs filed a motion for class certification in the six focus cases, which the District Court has not yet decided. On November 13, 2007, the defendants filed a motion to dismiss the complaint for failure to state a claim, which the District Court denied on March 8, 2008. We believe we have meritorious defenses to these claims and intend to defend against this action vigorously. In addition, in October 2007, a lawsuit was filed in the U.S. District Court for the Western District of Washington by Ms. Vanessa Simmonds against certain of the underwriters of the Company’s initial public offering. The plaintiff alleges that the underwriters violated Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. section 78p(b), by engaging in short-swing trades, and seeks disgorgement of profits from the underwriters in amounts to be proven at trial. On February 25, 2008, Ms. Simmonds filed an amended complaint. The suit names the Company as a nominal defendant, contains no claims against the Company, and seeks no relief from the Company.

 

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Other third parties have from time to time claimed, and others may claim in the future that the Company has infringed their past, current, or future intellectual property rights. The Company in the past has been forced to litigate such claims. These claims, whether meritorious or not, could be time-consuming, result in costly litigation, require expensive changes in our methods of doing business, or could require the Company to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm the Company’s business.

The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact on the Company’s results of operations, consolidated balance sheets and cash flows, due to defense costs, diversion of management resources and other factors.

 

(d) Indemnification

Many of our software license agreements require us to indemnify our customers for any claim or finding of intellectual property infringement. We periodically receive notices from customers regarding patent license inquiries they have received which may or may not implicate our indemnity obligations. Any litigation, brought by others, or us could result in the expenditure of significant financial resources and the diversion of management’s time and efforts. In addition, litigation in which we are accused of infringement might cause product shipment delays, require us to develop alternative technology or require us to enter into royalty or license agreements, which might not be available on acceptable terms, or at all. If a successful claim of infringement was made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could be significantly harmed. Such indemnification provisions are accounted for in accordance with SFAS No. 5 “Accounting for Contingencies” (“SFAS 5”). In prior periods, the Company has incurred minimal costs related to such claims under such indemnifications provisions; accordingly, the amount of such obligations cannot be reasonably estimated. The Company did however record a settlement charge resulting from a settlement of an infringement claim on the Company’s consolidated statement of operations for the year ended December 31, 2006, which was not considered material. There were no outstanding claims of infringement at June 30, 2008.

As permitted by Delaware law, the Company has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer is, or was, serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a director and officer insurance policy that limits its exposure and enables the Company to recover a portion of any such amounts. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is insignificant. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2008.

 

(e) Warranties

The Company generally provides a warranty for its software products and services to its customers. The Company’s products are generally warranted to perform substantially as described in the associated product documentation for a period of 90 days. The Company’s services are generally warranted to be performed consistent with industry standards for a period of 90 days from delivery. In the event there is a failure of such warranties, the Company generally is obligated to correct the product or service to conform to the warranty provision or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product or service. Such warranties are accounted for in accordance with SFAS 5. The Company has not provided for a warranty accrual as of June 30, 2008 or December 31, 2007 because, to date, the Company’s product warranty expense has not been significant. The Company assesses the need for a warranty reserve on a quarterly basis and there can be no guarantee that a warranty reserve will not become necessary in the future.

 

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Note 7. Restructuring Costs

The following table provides a summary of restructuring activity during the six months ended June 30, 2008 and 2007 (in thousands):

 

     Facilities  

Restructuring accruals:

  

Accrual as of December 31, 2006

   $ 6,102  

Payments made

     (2,054 )

Sublease payments received

     1,037  
        

Accrual as of June 30, 2007

   $ 5,085  
        

Accrual as of December 31, 2007

   $ 2,752  

Restructuring recoveries

     (482 )

Payments made

     (931 )

Sublease payments received

     236  
        

Accrual as of June 30, 2008

   $ 1,575  
        

In March 2008, we were notified by the subtenant of one of the facilities included in our restructuring accrual of their intent to lease additional space and extend their sublease through the end of our lease term. As a result of this agreement, we recorded a restructuring recovery of approximately $482,000. The agreement was executed in May 2008.

Note 8. Segment Information

The Company’s chief operating decision maker reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment: specifically the licensing and support of its software applications. Revenue classification is based upon customer location.

Geographic information on revenues for the three and six months ended June 30, 2008 and 2007 is as follows (in thousands):

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2008    2007    2008    2007

North America

   $ 12,389    $ 9,280    $ 26,590    $ 18,504

Europe

     3,947      3,980      7,614      7,612

Asia Pacific

     317      133      734      311
                           

Total

   $ 16,653    $ 13,393    $ 34,938    $ 26,427
                           

During the three months ended June 30, 2008, one customer accounted for 18% of total revenues. During the six months ended June 30, 2008 and during the three and six months ended June 30, 2007, no customer represented 10% or more of total revenues. As of June 30, 2008, one customer represented 24% of our gross accounts receivable.

Geographic information on the Company’s long-lived assets (Property and Equipment, net, and Other Assets), based on physical location, is as follows (in thousands):

 

     June 30,
2008
   December 31,
2007

United States

   $ 2,974    $ 2,854

International (primarily Europe)

     91      105
             

Total

   $ 3,065    $ 2,959
             

 

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Note 9. Line of Credit and Note Payable

 

(a) Line of Credit

On November 30, 2005, the Company established a banking relationship with Bridge Bank N.A. (“Bridge”) entering into a Business Financing Agreement and Intellectual Property Security Agreement with Bridge under which the Company had access to a loan facility of $7.0 million. The Company has since amended the agreement with Bridge, most recently on March 28, 2008, when the Company entered into a Second Amended and Restated Loan and Security Agreement with Bridge under which the Company has access to a loan facility of $10.0 million (“March Loan Facility”). The March Loan Facility is a formula-based revolving line of credit based on 80% of eligible receivables subject to three sublimits; a sublimit of $2.5 million that is available for stand-by letters of credit, foreign exchange contracts or cash management products. Existing equipment advances under the line of credit were converted into a term loan as of March 26, 2008 in the amount of $1.6 million, which is payable in 33 monthly installments of principal plus interest. A maximum amount of $500,000 is available for additional equipment financing. The total combined borrowing under the March Loan Facility and sublimits cannot exceed $10.0 million. The March Loan Facility is secured by all of the Company’s assets and expires February 27, 2010 at which time the entire balance under the formula-based line of credit will be due. The Company has until September 30, 2008 to draw down against the additional equipment financing, which is repayable over a 36 month period. Interest for the formula based revolving line of credit, the existing equipment advances and the additional equipment financing accrues at the Wall Street Journal’s (“WSJ”) Prime Lending Rate plus 1.25%. The March Loan Facility contains certain restrictive covenants including, but not limited to, certain financial covenants such as maintaining profitability net of stock-based compensation and maintenance of certain key ratios. If we are not in compliance with the covenants of the March Loan Facility, Bridge has the right to declare an event of default and all of the outstanding balances owed under the March Loan Facility would become immediately due and payable.

As of June 30, 2008, the Company had $1.4 million outstanding under the existing equipment loan. This amount is repayable in 31 monthly installments of principal and interest. It is shown on the condensed consolidated balance sheet under the headings of notes payable (current portion) and notes payable long-term. The Company has also drawn $1.5 million against the formula based revolving line of credit and $226,000 against the $500,000 available for additional equipment financing. The available balance of the March Loan Facility was also lowered by $116,000 to secure a letter of credit related to a building lease, leaving an available balance of $6.7 million as of June 30, 2008.

 

(b) Note Payable

As of June 30, 2008, there was $1.3 million classified as current portion of notes payable and $880,000 classified as long-term. The notes payable consist of five obligations. The first is the equipment loan from Bridge that is repayable in 31 monthly installments of principal and interest at prime plus 1.25%. The second is a promissory note with De Lage Landen Financial Services, Inc. for the financing of software license and support purchased and has a fixed interest rate of 3.15%, payable in monthly installments of principal and interest. The third obligation is with First Insurance Funding Corp. of California for short-term financing of Directors and Officers insurance and has a fixed interest rate of 9.87%, payable in monthly installments of principal and interest. The fourth is to former members of eVergance in connection with the acquisition of all the membership interests of eVergance and bears no interest. This note was recorded at its present value using a discount rate of 9.5%. The Company recognizes imputed interest expense as the notes mature. The fifth is a capital lease obligation, assumed from eVergance, for office furniture and equipment, which has a 5 year term, of which 24 months were remaining as of June 30, 2008, and an annual interest rate of 8.58%.

Note 10. Related Party Transactions

On October 30, 2006, the Company entered into a consulting agreement (“the Consulting Agreement”) with William T. Clifford, a member of KANA’s Board of Directors. Mr. Clifford provided consulting services to KANA’s management as an independent contractor on matters pertaining to strategic planning and business (in addition to his role as a member of the Board of Directors) for a period of twelve months that commenced on January 24, 2006. As of December 31, 2007, the Company had an accrued liability of $59,900 for his consulting services rendered pursuant to the terms of the consulting agreement. This amount was paid during the six months ended June 30, 2008.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as “anticipate,” “believe,” “estimate,” “expects,” “intend,” “plan,” “will” and variations of these words and similar expressions identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. These risks and uncertainties include, but are not limited to, those described in “Risk Factors” and elsewhere in this report. Forward-looking statements that were believed to be true at the time made may ultimately prove to be incorrect or false.

The following discussion should be read in conjunction with our Annual Report on Form 10-K filed on March 17, 2008, and the consolidated financial statements and notes thereto. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Overview

We offer an innovative approach to customer service with cost-effective solutions that enhance the quality of multi-channel customer interactions. Built on open standards for a high degree of adaptability and integration, our solutions intelligently automate the processes needed to successfully serve our clients’ customers, so that our clients can deliver higher value service at lower cost, increasing customer retention and loyalty. We provide an integrated solution that enables organizations to deliver consistent, managed service across all channels, including e-mail, chat, call centers and Web self-service, ensuring a consistent service experience across communication channels.

Our revenues are primarily derived from the sale of our software and related maintenance and support of the software. We also derive revenues from consulting, training and other services. Our products are generally installed by our customers using either a systems integrator, such as IBM or Accenture or our professional services group. Our professional services group assists the integrators as subject matter experts and in some cases will act as the prime contractor for implementation of our software. In June 2007 we acquired eVergance which expanded our professional services group’s capabilities and resources. We also rely on IBM and other systems integrators to recommend and install our software. This provides leverage in the selling phase, and also allows us to realize higher gross margins by selling primarily software licenses and support, which typically have higher margins than consulting and implementation services. In the past, we supplied specialists (who were subject matter experts) to work with IBM and other systems integrators. While we continue this practice, we are increasingly providing consulting and implementation services directly to our customers especially following our acquisition of eVergance. These services may be provided to our existing customers who would like us to review their implementations or to new customers who are not quite large enough to gain the interest of a large systems integrator to provide such services. However, in the case of most of the initial installations of our applications that are generally installed by our customers using a systems integrator, these services generally increase the cost of the project substantially by subjecting their purchase to more levels of required approvals and scrutiny of projected cost savings in their customer service and marketing departments. This contributes to the difficulty that we face in predicting the quarter in which sales to expected customers will occur and to the uncertainty of our future operating results. To the extent that significant sales occur earlier or later than anticipated, revenues for subsequent quarters may be lower or higher, respectively, than expected.

We have incurred substantial costs to develop our products and to recruit, train and compensate personnel for our engineering, sales, marketing, client services and administration departments. As a result, we have incurred substantial losses since inception. On June 30, 2008, we had cash and cash equivalents of $3.2 million. As of June 30, 2008, we had an accumulated deficit of $4.3 billion and a negative working capital of $10.9 million, of which $15.6 million relates to deferred revenue. We recorded a loss from operations of $53,000 and $3,000 for the three and six month periods ended June 30, 2008, and a loss from operations of $3.4 million loss and $7.1 million for the three and six month periods ended June 30, 2007, respectively. Net losses were $137,000 and $216,000 for the three and six months ended June 30, 2008, respectively and $3.5 million and $7.3 million for the three and six months ended June 30, 2007, respectively. Net cash used in operating activities was $951,000 and $4.9 million the six months ended June 30, 2008 and 2007, respectively. As of June 30, 2008, we had 234 full-time employees, which represents an increase from 225 employees at December 31, 2007 and a decrease from 244 employees at June 30, 2007.

 

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Critical Accounting Policies and Estimates

Our critical accounting policies and estimates are described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 17, 2008. We believe there have been no material changes to our critical accounting policies and estimates during the six months ended June 30, 2008 compared to those discussed in our Annual Report on Form 10-K for the year ended December 31, 2007.

Recent Accounting Pronouncements

Information with respect to Recent Accounting Pronouncements may be found in Note 1 to the Notes to the Unaudited Condensed Consolidated Financial Statements in “Part I. Financial Information — Item 1. Financial Statements” of this Quarterly Report on Form 10-Q.

Results of Operations

The following table sets forth selected data for the indicated periods. Percentages are expressed as a percentage of total revenues.

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2008     2007     2008     2007  
     (unaudited)     (unaudited)  

Revenues:

        

License fees

   24 %   26 %   28 %   27 %

Services

   76     74     72     73  
                        

Total revenues

   100     100     100     100  
                        

Costs and expenses:

         —    

Cost of license fees

   *     2     2     2  

Cost of services

   32     27     31     25  

Amortization of acquired intangible assets

   *     *     *     *  

Sales and marketing

   30     50     32     49  

Research and development

   21     23     19     25  

General and administrative

   16     23     17     25  

Restructuring recovery

   —       —       (1 )   —    
                        

Total costs and expenses

   100     125     100     127  
                        

Loss from operations

   *     (25 )   *     (27 )

Interest and other income (expense), net

   *     *     *     *  
                        

Loss before income tax expense

   *     (26 )   *     (27 )

Income tax expense

   *     *     *     *  
                        

Net loss

   * %   (26 )%   * %   (28 )%
                        

 

* Less than 1%

Revenues

Total revenues increased by 24% to $16.7 million for the three months ended June 30, 2008 from $13.4 million for the three months ended June 30, 2007, as a result of higher license and services revenues in 2008 than in 2007. Total revenues increased by 32% to $34.9 million for the six months ended June 30, 2008 from $26.4 million for the six months ended June 30, 2007, as a result of higher license and services revenues in 2008 than in 2007 based on increased demand for our products.

License revenues include licensing fees only, and exclude associated support and consulting revenue. The majority of our licenses to customers are perpetual and associated revenues are recognized upon delivery provided that all revenue recognition criteria are met as discussed in “Revenue Recognition” under Note 1 to the unaudited condensed consolidated financial statements of this Quarterly Report on Form 10-Q. License revenues increased by 13% to $4.0 million for the three

 

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months ended June 30, 2008 from $3.5 million for the same period in the prior year. License revenues increased by 36% to $9.7 million for the six months ended June 30, 2008 from $7.1 million for the same period in the prior year. While we had a lower numbers of transactions, the average transaction value increased due to the closing of one and three large transactions during the three and six months ended June 30, 2008, respectively. While we are focused on increasing license revenue, we are unable to predict such revenue from period to period with any degree of accuracy because, among other things, the market for our products is unpredictable and intensely competitive, and our sales cycle is long and unpredictable. The length of our sales cycle has increased in recent periods due to uncertain economic conditions.

Our services revenues consist of support revenues and professional services fees. Support revenues relate to providing customer support, product maintenance and updates to our customers. Professional services revenues relate to providing consulting, training and implementation services to our customers including enterprise on-demand. Services revenues increased 28% to $12.7 million for the three months ended June 30, 2008, compared to $9.9 million for the same period in 2007. Services revenues increased 31% to $25.2 million for the six months ended June 30, 2008, compared to $19.3 million for the same period in 2007. Support revenues are the largest component of services revenues. While there was an increase in support revenues in the three and six months ended June 30, 2008, the most significant increase was in consulting and training revenues that increased as a result of increased license sales in prior quarters and new consulting business from our acquisition of eVergance. Customers who purchase licenses frequently purchase implementation consulting and training services, which usually occur subsequent to the license sales.

Revenues from domestic sales were $12.4 million and $9.3 million for the three months ended June 30, 2008 and 2007, respectively and $26.6 million and $18.5 million for the six months ended June 30, 2008 and 2007, respectively. Revenues from international sales were $4.3 million and $4.1 million for the three months ended June 30, 2008 and 2007, respectively and $8.3 million and $7.9 million for the six months ended June 30, 2008 and 2007, respectively. Our international revenues were derived from sales in Europe and Asia Pacific.

Costs and Expenses

Total cost of revenues increased by 43% to $5.6 million for the three months ended June 30, 2008 from $3.9 million for the same period in 2007. Total cost of revenues increased by 58% to $11.6 million for the six months ended June 30, 2008 from $7.3 million for the same period in 2007.

License Fees. Cost of license fees consists of third party software royalties, referral fees, and costs of documentation. Cost of license fees as a percentage of license fees was 4% for the three months ended June 30, 2008, compared to 7% for the same period in the prior year. Cost of license fees as a percentage of license fees was 6% for the six months ended June 30, 2008, compared to 7% for the same period in the prior year. The decrease was partially due to a reduction in royalty costs associated with a relatively lower proportion of non-revenue-related shipments, such as upgrades and updates, as we had a lower proportion of such shipments during the first six months of 2008 and the phase out of certain royalty bearing products. This reduction was partially offset by a referral fee incurred during the six-month period in 2008. We expect that our cost of license fees as a percentage of sales will vary based on changes in the mix of products we sell and the timing of upgrades and that cost of license fees will generally range from approximately 5% to 10% of license revenue. We are continuing to look at alternatives for some original equipment manufacturer (“OEM”) products embedded in KANA products.

Services. Cost of services consists primarily of compensation and related expenses for our customer support, consulting and training and enterprise on-demand services organizations, and allocation of facility costs and system costs incurred in providing customer support. Cost of services increased to 42% of service revenues, or $5.3 million, for the three months ended June 30, 2008 compared to 37% of service revenues, or $3.7 million, for the same period in 2007. Cost of services increased to 43% of service revenues, or $10.8 million, for the six months ended June 30, 2008 compared to 35% of service revenues, or $6.7 million, for the same period in 2007. The decrease in service margins in the three and six month periods ended June 30, 2008 compared to the same periods in 2007 was due to an increase in professional services revenues as a percent of total service revenues, as the professional services have a higher cost of revenue. As of June 30, 2008, we had 67 employees in the support, consulting, training and enterprise on-demand organizations compared to 72 employees as of June 30, 2007, a decrease of 7%. This decrease was more than offset by the use of outside consultants.

Cost of services may increase or decrease depending on the demand for these services, and the revenue mix of such services. The expenses may also be affected by the amount, type and valuation of stock options granted as well as the amount of stock options cancelled due to employees and consultants leaving the Company.

Amortization of Acquired Intangible Assets. The amortization of acquired intangible assets recorded in the three-month periods ended June 30, 2008 and 2007 related to $2.5 million of identifiable intangibles purchased in connection with the eVergance acquisition in June 2007. The amortization of acquired intangible assets recorded in the six-month period ended June 30, 2008 related to assets purchased in connection with the eVergance acquisition in June 2007. The amortization of

 

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acquired intangible assets recorded in the six-month period ended June 30, 2007 related to assets purchased in connection with the eVergance acquisition in June 2007 and to $400,000 of identifiable assets purchased in connection with the Hipbone acquisition in February 2004. Acquired intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the assets (three and five years). The intangibles purchased in connection with the Hipbone acquisition were fully amortized in the first quarter of 2007.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing materials. Sales and marketing expenses decreased by 25% to $5.0 million for the three months ended June 30, 2008, from $6.7 million for the same period in 2007. Sales and marketing expenses decreased by 12% to $11.3 million for the six months ended June 30, 2008, from $12.9 million for the same period in 2007. This was primarily due to lower compensation costs as a result of decreased headcount and a reduction in our marketing programs. As of June 30, 2008, we had 64 employees in sales and marketing compared to 81 employees as of June 30, 2007, a decrease of 21%.

Sales and marketing expenses may increase or decrease, depending primarily on the amount of future revenues and our assessment of market opportunities and sales channels. The expenses may also be impacted by the amount, type and valuation of stock options granted as well as the amount of stock options cancelled due to employees and consultants leaving the Company.

Research and Development. Research and development expenses consist primarily of compensation and related costs for research and development employees and contractors and enhancement of existing products and quality assurance activities. Research and development expenses increased by 11% to $3.4 million for the three months ended June 30, 2008 from $3.1 million for the same period in 2007. Research and development expenses increased to $6.8 million for the six months ended June 30, 2008 from $6.7 million for the same period in 2007. The increase was attributable primarily to higher compensation and related costs as a result of an increase in head count offset by a reduction in the use of outside consultants. As of June 30, 2008, we had 61 employees in research and development compared to 48 employees as of June 30, 2007, an increase of 27%.

Research and development expenses including related head count may increase or decrease, depending primarily on the amount of future revenues, customer needs, and our assessment of market demand. The expenses may also be impacted by the amount, type and valuation of stock options granted as well as the amount of stock options cancelled due to employees and consultants leaving the Company.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for finance, legal, human resources, corporate governance, and bad debt expense. Information technology and facilities costs are allocated among all operating departments. General and administrative expenses decreased by 15% to $2.6 million for the three months ended June 30, 2008 from $3.1 million for the three months ended June 30, 2007. General and administrative expenses decreased by 12% to $5.8 million for the six months ended June 30, 2008 from $6.6 million for the six months ended June 30, 2007. The decrease in expenses during the three and six months ended June 30, 2008 was primarily due to lower legal fees and reduced cost of outside consultants offset for the six month period by higher auditing fees due to our 2007 audit of internal control over financial reporting. As of June 30, 2008, we had 42 employees in general and administrative and information technology combined compared to 43 employees as of June 30, 2007, a 2% decrease.

General and administrative expenses may increase or decrease, depending primarily on the amount of future revenues and corporate infrastructure requirements including insurance, professional services, taxes, bad debt expense, and other administrative costs. The expenses may also be impacted by the amount, type and valuation of stock options granted as well as the amount of stock options cancelled due to employees and consultants leaving the Company.

Restructuring Costs. During the six months ended June 30, 2008 we recorded a restructuring recovery of $482,000 as a result of the extension of a sublease on one of the properties in our restructuring accrual. There was no restructuring cost during the three or six months ended June 30, 2007.

Interest and Other Income (Expense), Net

Interest and other income (expense), net consists primarily of interest income and interest expense. Interest income and other income consists primarily of interest earned on cash and cash equivalents and was approximately $6,000 and $25,000 for the three months ended June 30, 2008 and 2007, respectively and $17,000 and $48,000 for the six months ended June 30, 2008 and 2007, respectively. The decrease in interest income related to lower cash and cash equivalents balances in the six months ended June 30, 2008 compared to the same period in 2007. Interest expense and other expense relates primarily to our line of credit and loan payable and was approximately $70,000 and $112,000 for the three months ended June 30, 2008 and 2007, respectively, and $184,000 and $154,000 for the six months ended June 30, 2008 and 2007, respectively. Interest expense varies from period-to-period based on the timing of borrowings and repayments.

 

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Provision for Income Taxes

We have a history of net losses on a consolidated basis from inception through June 30, 2008. Accordingly, we have recorded a valuation allowance for the full amount of our gross deferred tax assets, as the future realization of the tax benefit is not currently more likely than not. During the three months ended June 30, 2008 and 2007, certain of our foreign subsidiaries were profitable, based upon application of our intercompany transfer pricing agreements, which resulted in us reporting income tax expense totaling approximately $20,000 and $54,000 for the three months ended June 30, 2008 and 2007, respectively, and approximately $46,000 and $101,000 for the six months ended June 30, 2008 and 2007, respectively, in those foreign jurisdictions.

Liquidity and Capital Resources

As of June 30, 2008, we had $3.2 million in cash and cash equivalents, compared to $4.3 million in cash and cash equivalents at December 31, 2007. As of June 30, 2008, we had negative working capital of $10.9 million, compared to negative working capital of $11.6 million as of December 31, 2007. As of June 30, 2008, our current liabilities included $15.6 million of deferred revenue (primarily reflecting payments received for future maintenance services to be provided to our customers).

Primary Driver of Cash Flow

Our ability to generate cash in the future depends upon our success in generating sufficient sales transactions, especially new license transactions. Since our new license transactions are relatively small in number and are difficult to predict, we may not be able to generate new license transactions as anticipated in any particular future period. From time to time, changes in assets and liabilities, such as changes in levels of accounts receivable and accounts payable, may also affect our cash flows.

Operating Cash Flow

Our operating activities used $951,000 of cash for the first six months of 2008, which included a $216,000 net loss, a $1.4 million increase in accounts receivable, a $609,000 decrease in deferred revenue, and net payments of $695,000 against accrued restructuring and a restructuring recovery of $482,000, partially offset by non-cash charges of $1.1 million for stock-based compensation expense, and $587,000 of depreciation. Our operating activities used $4.9 million of cash and cash equivalents for the six months ended June 30 2007, due mainly to our net loss of $7.3 million, a $1.1 million decrease in accrued restructuring and a $442,000 increase in accounts receivable, partially offset by $1.5 million of non-cash stock-based compensation expense, as well as a $1.8 million increase in deferred revenue.

Investing Cash Flow

Our investing activities used $759,000 and $1.5 million of cash for the first six months of 2008 and 2007, respectively, which consisted primarily of the purchase of property and equipment and the purchase of eVergance in 2007.

Financing Cash Flow

Our financing activities generated $701,000 of cash for the six months ended June 30, 2008, which consisted of $2.1 million of borrowings under the line of credit offset by the repayment of $1.4 million on notes payable. For the first six months of 2007, our financing activities provided $5.1 million of cash and cash equivalents, due mainly to our borrowing of $4.2 million on our line of credit and $1.1 million of proceeds from issuance of common stock.

Existence and Timing of Contractual Obligations

On November 30, 2005, we established a banking relationship with Bridge Bank N.A. (“Bridge”)entering into a Business Financing Agreement and Intellectual Property Security Agreement with Bridge under which we had access to a loan facility of $7.0 million. We have since amended our agreement with Bridge, most recently on March 28, 2008, when we entered into a Second Amended and Restated Loan and Security Agreement with Bridge under which we had access to a loan facility of $10.0 million (“March Loan Facility”). The March Loan Facility is a formula based revolving line of credit based on 80% of eligible receivables subject to three sublimits; a sublimit of $2.5 million that is available for stand-by letters of credit, foreign exchange contracts or cash management products. Existing equipment advances under our line of credit were converted into a term loan as of March 26, 2008 in the amount of $1.6 million which is payable in 33 monthly installments of principal plus interest. A maximum amount of $500,000 is available for additional equipment financing. The total combined borrowing under the March Loan Facility and sublimits cannot exceed $10.0 million. The March Loan Facility is secured by all of our assets and expires February 27, 2010 at which time the entire balance under the formula-based line of credit will be due. We have until September 30, 2008 to draw down against the additional equipment financing, which is repayable over a 36 month period. Interest for the formula-based revolving line of credit, the existing equipment advances and the additional

 

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equipment financing accrues at the Wall Street Journal’s (“WSJ”) Prime Lending Rate plus 1.25%. The March Loan Facility contains certain restrictive covenants including but not limited to certain financial covenants such as maintaining profitability net of stock-based compensation and maintenance of certain key ratios. If we are not in compliance with the covenants of the March Loan Facility, Bridge has the right to declare an event of default and all of the outstanding balances owed under the March Loan Facility would become immediately due and payable.

As of June 30, 2008, we had $1.4 million outstanding under the March Loan Facility under the existing equipment loan provision. This amount is repayable in 31 monthly installments of principal and interest. It is shown on the condensed consolidated balance sheet under the headings of notes payable (current portion) and notes payable long-term. We have also drawn $1.5 million against the formula-based revolving line of credit and $226,000 against the $500,000 available for additional equipment financing. The available balance of the March Loan Facility was also lowered by $116,000 to secure a letter of credit related to a building lease, leaving an available balance of $6.7 million as of June 30, 2008.

Our future payments due under debt and lease obligations and other contractual commitments as of June 30, 2008 are as follows (in thousands):

 

     Payments Due By Period
     Total     Less than
1 year
    1-3
years
    3-5
years
   More than
5 years

Contractual obligations:

           

Line of credit (1)

   $ 1,726     $ 1,726         

Notes payable (2)

     2,189       1,309     $ 880     $ —      $ —  

Non-cancelable operating lease obligation (3)

     4,788       2,574       2,214       —        —  

Less: Sublease income (4)

     (1,168 )     (438 )     (730 )     —        —  

Other contractual obligations (5)

     6,899       1,106       2,918       2,875      —  
                                     

Total

   $ 14,434     $ 6,277     $ 5,282     $ 2,875    $ —  
                                     

 

(1) Includes receivables-based loans under our revolving credit which matures in 2010 but which may be payable sooner if we experience a decrease in receivables.

 

(2) Includes imputed interest on eVergance notes.

 

(3) Includes leases for properties included in the restructuring liability.

 

(4) Includes subleases that are under contract as of June 30, 2008.

 

(5) Represents payments on a legal settlement, minimum payments to vendors for future royalty fees, marketing services, and sales events.

Off-Balance-Sheet Arrangements

As of June 30, 2008, we did not have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Outlook

Outlook. Based on our current 2008 revenue expectations, we expect our cash and cash equivalents will be sufficient to meet our working capital and capital expenditure needs through June 30, 2009. If we do not experience anticipated demand for our products, we will need to further reduce costs, or issue equity securities or borrow money to meet our cash requirements. If we raise additional funds through the issuance of equity or convertible securities, the percentage ownership of our stockholders would be reduced and the securities we issue might have rights, preferences and privileges senior to those of our current stockholders. In addition, a rise in interest rates may impede our ability to borrow additional funds as well as maintain our current debt arrangements. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited. Our expectations as to our future cash flows and our future cash balances are subject to a number of assumptions, including anticipated increases in our revenues, improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control.

 

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Risk Factors That Could Affect Future Results

We operate in a dynamic and rapidly changing business environment that involves substantial risks and uncertainty, including but not limited to the specific risks identified below. The risks described below are not the only ones facing our company. Additional risks not presently known to us, or that we currently deem immaterial, may become important factors that impair our business operations. Any of these risks could cause, or contribute to causing, our actual results to differ materially from expectations. Prospective and existing investors are strongly urged to carefully consider the various cautionary statements and risks set forth in this report and our other public filings.

Risks Related to Our Business and Industry

We have a history of losses and may not be able to generate sufficient revenues to achieve and maintain profitability.

Since we began operations in 1997, our revenues have not been sufficient to support our operations, and we have incurred substantial operating losses every year. As of June 30, 2008, our accumulated deficit was approximately $4.3 billion, which includes approximately $2.7 billion related to goodwill impairment charges. Our stockholders’ equity on June 30, 2008 was $5.0 million. We continue to commit a substantial investment of resources to sales, product marketing and developing new products and enhancements, and we will need to increase our revenues to achieve profitability and positive cash flows. Our expectations as to when we can achieve positive cash flows, and as to our future cash balances, are subject to a number of assumptions, including assumptions regarding improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control. Our history of losses has previously caused some of our potential customers to question our viability, which has in turn hampered our ability to sell some of our products. Additionally, our revenues have been affected by the uncertain economic conditions in recent years, both generally and in our market. As a result of these conditions, we have experienced and expect to continue to experience difficulties in attracting new customers. Thus, even if sales of our products and services grow, we may continue to experience losses, which may cause the price of our stock to decline.

The relatively large size of many of our expected license transactions could contribute to our failure to meet expected sales in any given quarter and could materially harm our operating results.

Our revenues and results of operations may fluctuate as a result of a variety of factors. Our revenues are especially subject to fluctuation because they depend on the completion of relatively large orders for our products and related services. The average size of our license transactions is generally large relative to our total revenues in any quarter, particularly as we have focused on larger enterprise customers, on licensing our more comprehensive integrated products, and have involved systems integrators in our sales process. If sales expected from a specific customer in a particular quarter are not realized in that quarter, we are unlikely to be able to generate revenue from alternate sources in time to compensate for the shortfall. Fluctuations in our results of operations may be due to a number of additional factors, including, but not limited to, our ability to retain and increase our customer base, changes in our pricing policies or those of our competitors, the timing and success of new product introductions by us or our competitors, the sales cycle for our products, our fixed expenses, the purchasing and budgeting cycles of our clients, and general economic, industry and market conditions.

This dependence on large orders makes our revenues and operating results more likely to vary from quarter to quarter, and more difficult to predict, because the loss of any particular large order is significant. In recent periods, we have experienced increases in the length of a typical sales cycle and this trend has increased in 2008 as a result of uncertain economic conditions. This trend may add to the uncertainty of our future operating results and reduce our ability to anticipate our future revenues. Moreover, to the extent that significant sales occur earlier than anticipated, revenues for subsequent quarters may be lower than expected. As a result, our operating results could suffer if any large orders are delayed or canceled in any future period. In part as a result of this aspect of our business, our quarterly revenues and operating results may fluctuate in future periods and we may fail to meet the expectations of investors and public market analysts, which could cause the price of our common stock to decline.

We may not be able to forecast our revenues accurately because our products have a long and variable sales cycle and we rely on systems integrators for sales.

The long sales cycle for our products may cause license revenues and operating results to vary significantly from period to period. To date, the sales cycle for most of our product sales has taken anywhere from 6 to 9 months, and our typical sales cycle has increased recently as a result of uncertain economic conditions. Our sales cycle typically requires pre-purchase evaluation by a significant number of individuals within our customers’ organizations. Along with third parties that often jointly market our software with us, we invest significant amount of time and resources educating and providing information to prospective customers regarding the use and benefits of our products. Many of our customers evaluate our software slowly and deliberately, depending on the specific technical capabilities of the customer, the size of the deployment, the complexity of the customer’s network environment, and the quantity of hardware and the degree of hardware configuration necessary to deploy our products.

 

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Furthermore, we rely to a significant extent on systems integrators to identify, influence and manage large transactions with customers, and we expect this trend to continue as our industry consolidates. Selling our products in conjunction with our systems integrators who incorporate our products into their offerings can involve a particularly long and unpredictable sales cycle, as it typically takes more time for the prospective customer to evaluate proposals from multiple vendors. In addition, when systems integrators propose the use of our products to their customers, it is typically part of a larger project, which can require additional levels of customer approvals. We have little or no control over the sales cycle of an integrator-led transaction or our customers’ budgetary constraints and internal decision-making and acceptance processes.

As a result of increasingly long sales cycles, we have faced increased difficulty in predicting our operating results for any given period, and have experienced significant unanticipated fluctuations in our revenues from period to period. Any failure to achieve anticipated revenues for a period could cause our stock price to decline.

Our business relies heavily on customer service solutions, and these solutions may not gain market acceptance.

We have made customer service solutions our main focus and, have allocated a significant portion of our research and development and marketing resources to the development and promotion of such products. If these products are not accepted by potential customers, our business would be materially adversely affected. For our current business model to succeed, we believe that we will need to convince new and existing customers of the merits of purchasing our customer service solutions over traditional CRM solutions and competitors’ customer service solutions. Many of these customers have previously invested substantial resources in adopting and implementing their existing CRM products, whether such products are ours or are those of our competitors. We may be unable to convince customers and potential customers of the benefits of purchasing substantial new software packages that provide our specific customer service capabilities. If our strategy of offering customer service solutions fails, we may not be able to sell sufficient quantities of our product offerings to generate significant license revenues, and our business could be harmed.

Our expenses are generally fixed and we will not be able to reduce these expenses quickly if we fail to meet our revenue expectations.

Most of our expenses, such as employee compensation, are relatively fixed in the short term. Other expenses like leases are fixed and are more long term. Moreover, our forecast is based, in part, upon our expectations regarding future revenue levels. As a result, in any particular quarter our total revenues can be below expectation and we could not proportionately reduce operating expenses for that quarter. Accordingly, such a revenue shortfall would have a disproportionate negative effect on our expected operating results for that quarter.

If we fail to generate sufficient revenues to support our business and require additional financing, failure to obtain such financing would affect our ability to maintain our operations and to grow our business, and the terms of any financing we obtain may impair the rights of our existing stockholders.

In the future, we may be required to seek additional financing to fund our operations or growth, and such financing may not be available to us, or may impair the rights of our existing stockholders. Furthermore, any failure to raise sufficient capital in a timely fashion could prevent us from growing or pursuing our strategies or cause us to limit our operations and cause potential customers to question our financial viability. We had cash and cash equivalents of $3.2 million at June 30, 2008, and as of such date, had contractual commitments of $6.3 million during the next twelve months. It is possible that our cash position could decrease over the next few quarters and some customers could become increasingly concerned about our cash situation and our ongoing ability to update and maintain our products. This could significantly harm our sales efforts.

Factors such as the commercial success of our existing products and services, the timing and success of any new products and services, the progress of our research and development efforts, our results of operations, the status of competitive products and services, and the timing and success of potential strategic alliances or potential opportunities to acquire or sell technologies or assets may require us to seek additional funding sooner than we expect. In the event that we require additional cash, we may not be able to secure additional financing on terms that are acceptable to us, especially in the current uncertain market climate, and we may not be successful in implementing or negotiating other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and the securities we issue might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

If we fail to grow our customer base or generate repeat business, our operating results could be harmed.

Our business model generally depends on the sale of our products to new customers as well as on expanded use of our products within our customers’ organizations. If we fail to grow our customer base or generate repeat and expanded business from our current and future customers, our business and operating results will be seriously harmed. In some cases, our

 

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customers initially make a limited purchase of our products and services for pilot programs. These customers may not purchase additional licenses to expand their use of our products. If these customers do not successfully develop and deploy initial applications based on our products, they may choose not to purchase deployment licenses or additional development licenses. In addition, as we introduce new versions of our products, new product lines or new product features, our current customers might not require the additional functionality we offer and might not ultimately license these products. Furthermore, because the total amount of maintenance and support fees we receive in any period depends in large part on the size and number of licenses that we have previously sold, any downturn in our software license revenues would negatively affect our future services revenue. Also, if customers elect not to renew their support agreements, our services revenue could decline significantly. If customers are unable to pay for their current products or are unwilling to purchase additional products, our revenues would decline. Additionally, a substantial percentage of our sales come from repeat customers. If a significant existing customer or a group of existing customers decide not to repeat business with us, our revenues would decline and our business would be harmed.

We face substantial competition and may not be able to compete effectively.

The market for our products and services is intensely competitive, evolving, and subject to rapid technological change. From time to time, our competitors reduce the prices of their products and services (substantially in certain cases) to obtain new customers. Competitive pressures could make it difficult for us to acquire and retain customers and could require us to reduce the price of our products. Any such changes would likely reduce margins and could adversely affect operating results.

Our customers’ requirements and the technology available to satisfy those requirements are continually changing. Therefore, we must be able to respond to these changes in order to remain competitive. Changes in our products may also make it more difficult for our sales force to sell effectively. In addition, changes in customers’ demand for the specific products, product features and services of other companies may result in our products becoming uncompetitive. We expect the intensity of competition to increase in the future. Furthermore, we could lose market share if our competitors introduce new competitive products, add new functionality, acquire competitive products, reduce prices or form strategic alliances with other companies. We may not be able to compete successfully against current and future competitors, and competitive pressures may seriously harm our business.

Our competitors vary in size and in the scope and breadth of products and services offered. We currently face competition with our products from systems designed in-house and by our competitors. We expect that these systems will continue to be a major source of competition for the foreseeable future. Our primary competitors for electronic CRM platforms are larger, more established companies such as Oracle. We also face competition from Chordiant Software, ATG, Amdocs, Consona, Talisma, eGain, RightNow, Instranet, Inquira and Pegasystems with respect to specific applications we offer. We may face increased competition upon introduction of new products or upgrades from competitors, or if we expand our product line through acquisition of complementary businesses or otherwise. As we have combined and enhanced our product lines to offer a more comprehensive software solution, we are increasingly competing with large, established providers of customer management and communication solutions as well as other competitors. Our combined product line may not be sufficient to successfully compete with the product offerings available from these companies, which could slow our growth and harm our business.

Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we have. As a result, our competitors may be able to respond more quickly than we can to new or changing opportunities, technologies, standards or client requirements or devote greater resources to the promotion and sale of their products and services than we can. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. We may lose potential customers to competitors for various reasons, including the ability or willingness of competitors to offer lower prices and other incentives that we cannot match. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of recent industry consolidations, as well as anticipated future consolidations.

We rely on marketing, technology and distribution relationships for the sale, installation and support of our products that may generally be terminated at any time, and if our current and future relationships are not successful, our growth might be limited.

We rely on marketing and technology relationships with a variety of companies, including systems integrators and consulting firms that, among other things, generate leads for the sale of our products and provide our customers with implementation and ongoing support. If we cannot maintain successful marketing and technology relationships or if we fail to enter into such additional relationships, we could have difficulty expanding the sales of our products and our growth might be limited.

 

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A portion of our revenues depends on leads generated by systems integrators and their recommendations of our products. If systems integrators do not successfully market our products, our operating results will be materially harmed. In addition, many of our direct sales are to customers that will be relying on systems integrators to implement our products, and if systems integrators are not familiar with our technology or able to successfully implement our products, our operating results will be materially harmed. We expect to continue increasing our leverage of systems integrators as indirect sales channels and, if this strategy is successful, our dependence on the efforts of these third parties for revenue growth and customer service will remain high. Our reliance on third parties for these functions has reduced our control over such activities and reduced our ability to perform such functions internally. If we come to rely primarily on a single systems integrator that subsequently terminates its relationship with us, becomes insolvent or is acquired by another company with which we have no relationship, or decides not to provide implementation services related to our products, we may not be able to internally generate sufficient revenues or increase the revenues generated by our other systems integrator relationships to offset the resulting lost revenues. Furthermore, systems integrators typically suggest our solution in combination with other products and services, some of which may compete with our solution. Systems integrators are not required to promote any fixed quantities of our products and are not bound to promote our products exclusively and may act as indirect sales channels for our competitors. If systems integrators choose not to promote our products or if they develop, market or recommend software applications that compete with our products, our business will be harmed.

In addition to relying on systems integrators to recommend our products, we also rely on systems integrators and other third-party resellers to install and support our products. If the companies providing these services fail to implement our products successfully for our customers, the customer may be unable to complete implementation on the schedule that it had anticipated and we may have increased customer dissatisfaction or difficulty making future sales as a result. We might not be able to maintain our relationships with systems integrators and other indirect sales channel partners and enter into additional relationships that will provide timely and cost-effective customer support and service. If we cannot maintain successful relationships with our indirect sales channel partners, we might have difficulty expanding the sales of our products and our growth could be limited. In addition, if such third parties do not provide the support our customers need, we may be required to hire subcontractors to provide these professional services. Increased use of subcontractors would harm our margins because it costs us more to hire subcontractors to perform these services than it would to provide the services ourselves.

Because certain customers account for a substantial portion of our revenues, the loss of a significant customer could cause a substantial decline in our revenues.

During the three months ended June 30, 2008, one customer accounted for 18% of total revenues. During the six months ended June 30, 2008 and during the three and six months ended June 30, 2007, no customer represented 10% or more of our total revenues. If we lose major customers, or if a contract is delayed or cancelled or we do not contract with new major customers, our revenues and net loss would be adversely affected. In addition, customers that have accounted for significant revenues in the past may not generate revenues in any future period, and our failure to obtain new significant customers or additional orders from existing customers could materially affect our operating results.

We may not receive significant revenues from our current research and development efforts for several years, if at all.

Developing and localizing software is expensive and the investment in product development often involves a long payback cycle. We have and expect to continue making significant investments in software research and development and related product opportunities. Enhancing our products and pursuing new product developments require high levels of expenditures for research and development that could adversely affect our operating results if not offset by revenue increases. We believe that we must continue to dedicate a significant amount of resources to our research and development efforts to maintain our competitive position. However, we do not expect to receive significant revenues from these investments for several years, if at all.

If our cost reduction and restructuring efforts are ineffective, our revenues and profitability may be hurt.

In July 2007, we undertook various cost reduction and restructuring activities. The expense related to our reduction in work force was approximately $240,000 and expense related to ceasing use of one of our offices was approximately $8,000. In September 2007, we agreed with the landlord of one of the facilities included in our restructuring accrual to surrender the remaining term of the lease in exchange for a lump sum cash payment. As a result of this agreement, we recorded additional restructuring expense of approximately $319,000. In March 2008, we were notified by the subtenant of one of the facilities included in our restructuring accrual of their intent to lease additional space and extend their sublease through the end of our lease term. As a result of this agreement, we recorded a restructuring recovery of approximately $482,000. The agreement was executed in May 2008. In addition, the cost reduction and restructuring activities may not produce the full efficiencies and benefits we expect or the efficiencies and benefits might be delayed. There can be no assurance that these efforts, as well as any potential future cost reduction and restructuring activities, will not adversely affect our business, operations or customer perceptions, or result in additional future charges.

 

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We may be unable to hire and retain the skilled personnel necessary to develop and grow our business.

We rely on the continued service of our senior management and other key employees and the hiring of new qualified employees. In the software industry, there is substantial and continuous competition for highly skilled business, product development, technical and other personnel. Given the concern over our long-term financial strength, we may not be successful in recruiting and integrating new personnel and retaining and motivating existing personnel, which could lead to increased turnover and reduce our ability to meet the needs of our current and future customers. Because our stock price declined drastically in recent years, and has not experienced any sustained recovery from the decline, stock-based compensation, including options to purchase our common stock, may have diminished effectiveness as employee hiring and retention devices. If we are unable to retain qualified personnel, we could face disruptions to operations, loss of key information, expertise or know-how and unanticipated additional recruitment and training costs. If employee turnover increases, our ability to provide customer service and execute our strategy would be negatively affected.

For example, our ability to increase revenues in the future depends considerably upon our success in training and retaining effective direct sales personnel and the success of our direct sales force. We might not be successful in these efforts. Our products and services require sophisticated sales efforts. We have experienced significant turnover in our sales force including domestic senior sales management, and may experience further turnover in future periods. It generally takes a new salesperson nine or more months to become productive, and they may not be able to generate new sales. Our business will be harmed if we fail to retain qualified sales personnel, or if newly hired salespeople fail to develop the necessary sales skills or develop these skills more slowly than anticipated. Additionally, we continue to need to recruit experienced developers as a result of our initiative to eliminate outsourced product development and bring core technology development back to our personnel in the United States.

If we fail to respond to changing customer preferences in our market, demand for our products and our ability to enhance our revenues will suffer.

If we do not continue to improve our products and develop new products that keep pace with competitive product introductions and technological developments, satisfy diverse and rapidly evolving customer requirements, and achieve market acceptance, we might be unable to attract new customers. Our industry is characterized by rapid and substantial developments in the technologies and products that enjoy widespread acceptance among prospective and existing customers. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. We might not be successful in marketing and supporting our products or developing and marketing other product enhancements and new products that respond to technological advances and market changes, on a timely or cost-effective basis. In addition, even if these products are developed and released, they might not achieve market acceptance. We have experienced delays in releasing new products and product enhancements in the past and could experience similar delays in the future. These delays or problems in the installation or implementation of our new releases could cause us to lose customers.

Our failure to manage multiple technologies and technological change could reduce demand for our products.

Rapidly changing technology and operating systems, changes in customer requirements, and evolving industry standards might impede market acceptance of our products. Our products are designed based upon currently prevailing technology to work on a variety of hardware and software platforms used by our customers. However, our software may not operate correctly on evolving versions of hardware and software platforms, programming languages, database environments and other systems that our customers use. If new technologies emerge that are incompatible with our products, or if competing products emerge that are based on new technologies or new industry standards and that perform better or cost less than our products, our key products could become obsolete and our existing and potential customers could seek alternatives to our products. We must constantly modify and improve our products to keep pace with changes made to these platforms and to database systems and other back-office applications and Internet-related applications. Furthermore, software adapters are necessary to integrate our products with other systems and data sources used by our customers. We must develop and update these adapters to reflect changes to these systems and data sources in order to maintain the functionality provided by our products. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by vendors of operating systems, databases, CRM software, Web servers and other enterprise and Internet-based applications could delay our product development, increase our product development expense or cause customers to delay evaluation, purchase and deployment of our analytics products. If we fail to modify or improve our products in response to evolving industry standards, our products could rapidly become obsolete.

Our success depends upon our ability to develop new products and enhance our existing products on a timely basis.

The challenges of developing new products and enhancements require us to commit a substantial investment of resources to development, and we might not be able to develop or introduce new products on a timely or cost-effective basis, or at all, which could be exploited by our competitors and lead potential customers to choose alternative products. To be

 

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competitive, we must develop and introduce on a timely basis new products and product enhancements for companies with significant e-business customer interaction needs. Our ability to deliver competitive products may be negatively affected by the diversion of resources to development of our existing suite of products, and responding to changes in competitive products and in the demands of our customers. If we experience product delays in the future, we may face:

 

   

customer dissatisfaction;

 

   

cancellation of orders and license agreements;

 

   

negative publicity;

 

   

loss of revenues; and

 

   

slower market acceptance.

Furthermore, delays in bringing new products or enhancements to market can result, for example, from loss of institutional knowledge through reductions in force, or the existence of defects in new products or their enhancements.

Failure to license necessary third-party software incorporated in our products could cause delays or reductions in our sales.

We license third-party software that we incorporate into our products. These licenses may not continue to be available on commercially reasonable terms or at all. Some of this technology would be difficult to replace. The loss of any of these licenses could result in delays or reductions in the development and deployment of our applications until we identify, license and integrate, or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could face higher royalty payments and our products may lose certain attributes or features. In the future, we might need to license other software to enhance our products and meet evolving customer needs. If we are unable to do this, we could experience reduced demand for our products.

Defects in third-party products associated with our products could impair our products’ functionality and injure our reputation.

The effective implementation of our products depends upon the successful operation of third-party products in conjunction with our products. Any undetected defects in these third-party products could prevent the implementation or impair the functionality of our products, delay new product introductions or injure our reputation.

We have identified a material weakness in our internal control over financial reporting that, if not remediated, could affect our ability to prepare timely and accurate financial reports, which could cause investors to lose confidence in our reported financial information and have a negative effect on the trading price of our stock.

In connection with the preparation of our 2007 Annual Report, we identified and reported a material weakness in our internal controls over the period-end reporting process, including controls with respect to the review, supervision and monitoring of accounting operations for both domestic and international operations. As a result of this material weakness, we are unable to conclude that our internal control over financial reporting was effective as of June 30, 2008.

Our management, with the oversight of the Audit Committee, is addressing this material weakness and is committed to effective remediation of these deficiencies as expeditiously as possible. We have effected personnel changes in our accounting and financial reporting functions. We will continue our efforts to establish or modify specific processes and controls to provide reasonable assurance with respect to the accuracy and integrity of accounting entries and account reconciliations and the appropriate review and approval thereof. Our material weakness will not be considered remediated until new internal controls are developed and implemented and are operational for a period of time and are tested. In September 2007, we implemented a new enterprise resource planning (“ERP”) system. We expect that the system will improve the reliability of our financial reporting by reducing the need for manual processes, subjective assumptions, and management discretion; the opportunities for errors and omissions; and our reliance on manual controls to detect and correct accounting and financial reporting inaccuracies. However, the implementation of this new ERP system has caused delays in reporting and performance of manual controls while personnel worked on the change in system reporting. Our management will continue to review and make necessary changes to the overall design of our internal control environment, as well as policies and procedures to improve the overall effectiveness of internal control over financial reporting.

Our remediation measures may not be successful in correcting the material weakness related to our period-end reporting process. In addition, we cannot assure you that additional material weaknesses or significant deficiencies in our internal control will not be discovered in the future. In addition, internal controls may become inadequate because of changes in conditions and the degree of compliance with the policies or procedures may deteriorate. Any failure to remediate the material weakness described above or to implement and maintain effective internal control over financial reporting could harm our operating results, delay our completion of our consolidated financial statements and our independent registered

 

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public accounting firm’s audit or review of our consolidated financial statements which could cause us to fail to timely meet our periodic reporting obligations with the SEC, or result in material misstatements in our consolidated financial statements which could also cause us to fail to timely meet our periodic reporting obligations with the SEC. Deficiencies in our internal control over financial reporting could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

Our common stock is currently quoted on the OTCBB.

Our common stock was delisted from The NASDAQ Global Market effective at the opening of business on October 17, 2005 due to the failure to timely file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005 with the SEC. From October 17, 2005 to December 4, 2006, our common stock was quoted on the “Pink Sheets” and as of December 5, 2006, our common stock has been quoted on Over the Counter Bulletin Board (“OTCBB”). The OTCBB is generally considered less efficient than The NASDAQ Global Market. Quotation of our common stock on the OTCBB may reduce the liquidity of our securities, limit the number of investors who trade in our securities, result in a lower stock price and larger spread in the bid and ask prices for shares of our common stock and could have an adverse effect on us. Additionally, we may become subject to the SEC rules that affect “penny stocks,” which are stocks below $5.00 per share that are not quoted on The NASDAQ Global Market. These SEC rules would make it more difficult for brokers to find buyers for our securities and could lower the net sales prices that our stockholders are able to obtain. If our price of common stock remains low, we may not be able to raise equity capital.

Our listing on the OTCBB or further declines in our stock price may greatly impair our ability to raise additional necessary capital through equity or debt financing, and significantly increase the dilution to our current stockholders caused by any issuance of equity in financing or other transactions. The price at which we would issue shares in such transactions is generally based on the market price of our common stock and a decline in the stock price could result in our need to issue a greater number of shares to raise a given amount of funding.

In addition, because our common stock is not listed on a principal national exchange, we are subject to Rule 15g-9 under the Exchange Act, which imposes additional sales practice requirements on broker-dealers that sell low-priced securities to persons other than established customers and institutional accredited investors. For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to sale. Consequently, the rule may affect the ability of broker-dealers to sell our common stock and affect the ability of holders to sell their shares of our common stock in the secondary market. Moreover, investors may be less interested in purchasing low-priced securities because the brokerage commissions, as a percentage of the total transaction value, tend to be higher for such securities, and some investment funds will not invest in low-priced securities (other than those which focus on small-capitalization companies or low-priced securities).

Our stock price has been highly volatile and has experienced a significant decline, and may continue to be volatile and decline.

The trading price of our common stock has fluctuated widely in the past and we expect that it will continue to do so in the future. Since becoming a publically traded security listed on The NASDAQ Global Market in September 1999, our common stock has reached a sales price high of $1,698.10 per share and a sales price low of $0.65 per share. The last reported sale price of our shares on August 5, 2008 was $1.10 per share. These fluctuations are the result of a number of factors, many of which are outside of our control, such as:

 

   

variations in our actual and anticipated operating results;

 

   

changes in our earnings estimates by analysts;

 

   

the volatility inherent in stock prices within the emerging sector within which we conduct business; and

 

   

the volume of trading in our common stock, including sales of substantial amounts of common stock issued upon the exercise of outstanding options and warrants.

In addition, stock markets in general have, and particularly The NASDAQ Global Market and the OTCBB have, experienced extreme price and volume fluctuations that have affected the market prices of many technology and computer software companies, particularly Internet-related companies. Such fluctuations have often been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. Securities class action litigation could result in substantial costs and a diversion of our management’s attention and resources.

 

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Our pending patents may never be issued and, even if issued, may provide little protection.

Our success and ability to compete depend upon the protection of our software and other proprietary technology rights. We currently have six issued U.S. patents, four of which expire in 2018 and two of which expire in 2020, and multiple U.S. patent applications pending relating to our software. None of our technology is patented outside of the United States. It is possible that:

 

   

our pending patent applications may not result in the issuance of patents;

 

   

any issued patents may not be broad enough to protect our proprietary rights;

 

   

any issued patents could be successfully challenged by one or more third parties, which could result in our loss of the right to prevent others from exploiting the inventions claimed in those patents;

 

   

current and future competitors may independently develop similar technology, duplicate our products or design around any of our patents; and

 

   

effective patent protection may not be available in every country in which we do business.

We rely upon trademarks, copyrights and trade secrets to protect our proprietary rights, which may not be sufficient to protect our intellectual property.

In addition to patents, we rely on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. However, despite the precautions that we have taken:

 

   

laws and contractual restrictions may not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies;

 

   

current federal laws that prohibit software copying provide only limited protection from software “pirates,” and effective trademark, copyright and trade secret protection may be unavailable or limited in foreign countries;

 

   

other companies may claim common law trademark rights based upon state or foreign laws that precede the federal registration of our marks; and

 

   

policing unauthorized use of our products and trademarks is difficult, expensive and time-consuming, and we may be unable to determine the extent of this unauthorized use.

The laws of foreign countries in which we market our products may offer little or no effective protection of our proprietary technology. Consequently, we may be unable to prevent our proprietary technology from being exploited abroad, which could diminish international sales or require costly efforts to protect our technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which would significantly harm our business.

We may become involved in litigation over proprietary rights, which could be costly and time consuming.

The software industry is characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights, and our technologies may not be able to withstand any third-party claims or rights against their use. Some of our competitors in the market for customer communications software may have filed or may intend to file patent applications covering aspects of their technology that they may claim our technology infringes. Such competitors could make a claim of infringement against us with respect to our products and technology. Additionally, third parties may currently have, or may eventually be issued, patents upon which our current or future products or technology infringe and any of these third parties might make a claim of infringement against us. For example, during 2006 and 2007 we were involved in litigation brought by Polaris IP, LLC against us and certain of our customers that claimed that certain of our products violate patents held by them.

As we grow, the possibility of intellectual property rights claims against us increases. We may not be able to withstand any third-party claims and regardless of the merits of the claim, any intellectual property claims could be inherently uncertain, time-consuming and expensive to litigate or settle. Many of our software license agreements require us to indemnify our customers from any claim or finding of intellectual property infringement. We periodically receive notices from customers regarding patent license inquiries they have received which may or may not implicate our indemnity obligations. Any litigation, brought by others, or us could result in the expenditure of significant financial resources and the diversion of management’s time and efforts. In addition, litigation in which we are accused of infringement might cause product shipment delays, require us to develop alternative technology or require us to enter into royalty or license agreements, which might not be available on acceptable terms, or at all. If an infringement claim is made against us, we may not be able to develop non-infringing technology or license the infringing or similar technology on a timely and cost-effective basis. As a result, our business could be significantly harmed.

 

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We may face liability claims that could result in unexpected costs and damages to our reputation.

Our licenses with customers generally contain provisions designed to limit our exposure to potential product liability claims, such as disclaimers of warranties and limitations on liability for special, consequential and incidental damages. In addition, our license agreements generally limit the amounts recoverable for damages to the amounts paid by the licensee to us for the product or service giving rise to the damages. However, some domestic and international jurisdictions may not enforce these contractual limitations on liability. We may be subject to claims based on errors in our software or mistakes in performing our services including claims relating to damages to our customers’ internal systems. A product liability claim could divert the attention of our management and key personnel, could be expensive to defend and could result in adverse settlements and judgments.

We may face higher costs and lost sales if our software contains errors.

We face the possibility of higher costs as a result of the complexity of our products and the potential for undetected errors. Due to the critical nature of many of our products and services, errors could be particularly problematic. In the past, we have discovered software errors in some of our products after their introduction. We only have a few “beta” customers that test new features and functionality of our software before we make these features and functionalities generally available to our customers. If we are not able to detect and correct errors in our products or releases before commencing commercial shipments, we could face:

 

   

loss of or delay in revenues expected from new products and an immediate and significant loss of market share;

 

   

loss of existing customers that upgrade to new products and of new customers;

 

   

failure to achieve market acceptance;

 

   

diversion of development resources;

 

   

injury to our reputation;

 

   

increased service and warranty costs;

 

   

legal actions by customers; and

 

   

increased insurance costs.

Any of the foregoing potential results of errors in our software could adversely affect our business, financial condition and results of operations.

Our security could be breached, which could damage our reputation and deter customers from using our services.

We must protect our computer systems and network from physical break-ins, security breaches, and other disruptive problems caused by the Internet or other users. Computer break-ins could jeopardize the security of information stored in and transmitted through our computer systems and network, which could adversely affect our ability to retain or attract customers, damage our reputation, and subject us to litigation. We have been in the past, and could be in the future, subject to denial of service, vandalism, and other attacks on our systems by Internet hackers. Although we intend to continue to implement security technology and establish operational procedures to prevent break-ins, damage and failures, these security measures may fail. Our insurance coverage in certain circumstances may be insufficient to cover losses that may result from such events.

We have significant international sales and are subject to risks associated with operating in international markets.

A substantial proportion of our revenues are generated from sales outside North America, exposing us to additional financial and operational risks. Sales outside North America represented 26% and 24% of out total revenues for the three and six month periods ended June 30, 2008, respectively. Sales outside North America represented 25%, 32% and 30% of our total revenues for 2007, 2006 and 2005, respectively. We have established offices in the United States, Europe and Japan. Sales outside North America could increase as a percentage of total revenues as we attempt to expand our international operations. In addition to the additional costs and uncertainties of being subject to international laws and regulations, international operations require significant management attention and financial resources, as well as additional support personnel. To the extent our international operations grow, we will also need to, among other things, expand our international sales channel management and support organizations and develop relationships with international service providers and additional distributors and systems integrators. International operations are subject to many inherent risks, including:

 

   

political, social and economic instability, including conflicts in the Middle East and elsewhere abroad, terrorist attacks and security concerns in general;

 

   

adverse changes in tariffs, duties, price controls and other protectionist laws and business practices that favor local competitors;

 

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fluctuations in currency exchange rates;

 

   

longer collection periods and difficulties in collecting receivables from foreign entities;

 

   

exposure to different legal standards and burdens of complying with a variety of foreign laws, including employment, tax, privacy and data protection laws and regulations;

 

   

reduced protection for our intellectual property in some countries;

 

   

increases in tax rates;

 

   

greater seasonal fluctuations in business activity;

 

   

expenses associated with localizing products for foreign countries, including translation into foreign languages;

 

   

difficulty and cost of staffing and managing international operations; and

 

   

import and export license requirements and restrictions of the United States and each other country in which we operate.

We believe that international sales will continue to represent a significant portion of our revenue for the foreseeable future. Any of these factors may adversely affect our future international sales and, consequently, affect our business, financial condition and results of operations.

We may suffer foreign exchange rate losses.

Our international revenues and expenses are denominated in local currency. Therefore, a weakening of the U.S. dollar to other currencies could make our products more costly to sell in foreign markets and could negatively affect our operating results and cash flows. We have not yet experienced, but may in the future experience, significant foreign currency transaction losses, especially because we generally do not engage in currency hedging. To the extent the international component of our revenues grows, our results of operations will become more sensitive to foreign exchange rate fluctuations.

If we acquire companies, products, or technologies, we may face risks associated with those acquisitions.

In June 2007, we acquired all of the membership interests of eVergance. We may not fully realize the anticipated benefits of the eVergance acquisition or any other acquisition or investment. For example, since our inception, we have recorded $2.7 billion of impairment charges for the cost of goodwill obtained from acquisitions. If we acquire another company, we will likely face risks, uncertainties and disruptions associated with the integration process, including, among other things, difficulties in the integration of the operations, technologies and services of the acquired company, the diversion of our management’s attention from other business concerns, the potential loss of key employees of the acquired businesses, and the failure of the acquired businesses, products or technologies to generate sufficient revenue to offset acquisition costs. If we fail to successfully integrate other companies that we may acquire, our business could be harmed. Also, acquisitions, including the acquisition of eVergance, can expose us to liabilities and risks facing the company we acquire, such as lawsuits or claims against us that are unknown at the time of the acquisition. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be dilutive to our existing stockholders. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired goodwill and other intangible assets. These factors could have an adverse effect on our business, results of operations, financial condition or cash flows.

Compliance with regulations governing public company corporate governance and reporting will result in additional costs.

The implementation of various corporate governance reforms and enhanced disclosure laws and regulations adopted in recent years requires us to incur significant additional accounting and legal costs. We are subject to accounting disclosures required by laws and regulations adopted in connection with the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). In particular, we are required to provide a report on our internal control over financial reporting required by Section 404 of the Sarbanes-Oxley Act. Any unanticipated difficulties in preparing for and implementing these and other corporate governance and reporting reforms could result in material delays in compliance or significantly increase our costs. Any failure to timely prepare for and implement the reforms required by new laws and regulations could significantly harm our business, operating results and financial condition.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of the Company.

Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock. Without any further vote or action on the part of the stockholders, the Board of Directors has the authority to determine the price, rights, preferences, privileges, and restrictions of the preferred stock. This preferred stock, if issued, might have preference over and harm the

 

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rights of the holders of common stock. Although the ability to issue this preferred stock provides us with flexibility in connection with possible acquisitions and other corporate purposes, it can also be used to make it more difficult for a third party to acquire a majority of our outstanding voting stock. We currently have no plans to issue preferred stock. Similarly, we have established a stockholder rights plan that is intended to protect our ability to utilize our net operating losses and which would also make it difficult for a third party to acquire a significant number of shares of our common stock.

Our certificate of incorporation, bylaws and equity compensation plans include provisions that may deter an unsolicited offer to purchase us. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede a merger, tender offer or proxy contest. Furthermore, our Board of Directors is divided into three classes, only one of which is elected each year. In addition, directors are only removable by the affirmative vote of at least two-thirds of all classes of voting stock. These factors may further delay or prevent a change of control of us.

Risks Related to Our Industry

Future regulation of the Internet may slow our growth, resulting in decreased demand for our products and services and increased costs of doing business.

State, federal and foreign regulators could adopt laws and regulations that impose additional burdens on companies that conduct business online. These laws and regulations could discourage communication by e-mail or other web-based communications, particularly targeted e-mail of the type facilitated by our products, which could reduce demand for our products and services.

The growth and development of the market for online services may prompt calls for more stringent consumer protection laws or laws that may inhibit the use of Internet-based communications or the information contained in these communications. The adoption of any additional laws or regulations may decrease the expansion of the Internet. A decline in the growth of the Internet, particularly as it relates to online communication, could decrease demand for our products and services and increase our costs of doing business, or otherwise harm our business. Any new legislation or regulations, application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or application of existing laws and regulations to the Internet and other online services could increase our costs and harm our growth.

The imposition of sales and other taxes on products sold by our customers over the Internet could have a negative effect on online commerce and the demand for our products and services.

The imposition of new sales or other taxes could limit the growth of Internet commerce generally and, as a result, the demand for our products and services. Federal legislation that limits the imposition of state and local taxes on Internet-related sales will expire on November 1, 2014. Congress may choose to modify this legislation or to allow it to expire, in which case state and local governments would be free to impose taxes on electronically purchased goods. We believe that most companies that sell products over the Internet do not currently collect sales or other taxes on shipments of their products into states or foreign countries where they are not physically present. However, one or more states or foreign countries may seek to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in e-commerce within their jurisdiction. A successful assertion by one or more states or foreign countries that companies that engage in e-commerce within their jurisdiction should collect sales or other taxes on the sale of their products over the Internet, even though not physically in the state or country, could indirectly reduce demand for our products.

The success of our products depends on the continued growth and acceptance of the Internet as a business and communications tool, and the related expansion of the Internet infrastructure.

The future success of our products depends upon the continued and widespread adoption of the Internet as a primary medium for commerce, communication and business applications. Our business growth would be impeded if the performance or perception of the Internet was harmed by security problems such as “viruses,” “worms” and other malicious programs, reliability issues arising from outages and damage to Internet infrastructure, delays in development or adoption of new standards and protocols to handle increased demands of Internet activity, increased costs, decreased accessibility and quality of service, or increased government regulation and taxation of Internet activity.

The Internet has experienced, and is expected to continue to experience, significant user and traffic growth, which has, at times, caused user frustration with slow access and download times. If Internet activity grows faster than Internet infrastructure or if the Internet infrastructure is otherwise unable to support the demands placed on it, our business growth may be adversely affected.

 

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General economic conditions could adversely affect our customers’ ability or willingness to purchase our products, which could materially and adversely affect our results of operations.

Our customers consist of large and small companies in nearly all industry sectors and geographies. Potential new clients or existing clients could defer purchases of our products because of unfavorable macroeconomic conditions, such as rising interest rates, fluctuations in currency exchange rates, industry or national economic downturns, industry purchasing patterns, and other factors. Our ability to grow revenues may be adversely affected by unfavorable macroeconomic conditions.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

We develop products in the United States and sell these products in North America, Europe, and Asia. In the three and six months ended June 30, 2008 revenues from customers outside of the United States approximated 26% and 24% of total revenues, respectively. In the years ended December 31, 2007, 2006 and 2005, revenues from customers outside of the United States approximated 25%, 32% and 30%, respectively, of total revenues. Generally, our sales are made in the local currency of our customers. As a result, our financial results and cash flows could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. We rarely use derivative instruments to hedge against foreign exchange risk. As such, we are exposed to market risk from fluctuations in foreign currency exchange rates, principally from the exchange rate between the U.S. dollar and the Euro and the British pound. We manage exposure to variability in foreign currency exchange rates primarily due to the fact that liabilities and assets, as well as revenues and expenses, are denominated in the local currency. However, different durations in our funding obligations and assets may expose us to the risk of foreign exchange rate fluctuations. We have not entered into any derivative instrument transactions to manage this risk. Based on our overall foreign currency rate exposure at June 30, 2008, we do not believe that a hypothetical 10% change in foreign currency rates would materially adversely affect our financial position or results of operations. We do not consider our cash equivalents to be subject to interest rate risk due to their short maturities.

 

ITEM 4. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures.

In connection with the preparation of this report, our management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation and the identification of a material weakness in internal control over financial reporting as described in our Annual Report on Form 10-K for the year ended December 31, 2007, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective as of June 30, 2008.

Changes in Internal Control over Financial Reporting

As previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, we determined that we did not maintain effective internal controls over the period-end financial reporting process, including internal controls with respect to review, supervision, and monitoring of accounting operations for our domestic and international operations.

During the first quarter of fiscal year 2008, we began the implementation of remedial measures, including (a) certain personnel actions; (b) a more rigorous period-end financial reporting policy and process involving journal-entry approval, supporting documentation, account reconciliations, and accrual review; (c) system-generated controls to eliminate manual controls; and (d) increased oversight of international reporting.

We consider remediation of the material weakness in our period-end financial reporting process a significant priority in the operation of the Company. We will continue our efforts in this regard and believe that we will achieve full remediation in the near future.

Except for the changes described above, there have been no changes during the quarter ended June 30, 2008 in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II: OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

On January 24, 2007, RightNow Technologies, Inc. (“RightNow”) filed a suit in the Eighteenth Judicial District Court of Gallatin County, Montana against the Company and four former RightNow employees who had joined the Company. The suit alleges violation of certain provisions of employment agreements, misappropriation of trade secrets, as well as other claims, and seeks damages. We believe we have meritorious defenses to these claims and intend to defend against this action vigorously.

The underwriters for our initial public offering, Goldman Sachs & Co., Lehman Bros., Hambrecht & Quist LLC, Wit Soundview Capital Corp., as well as us and certain of our current and former officers o were named as defendants in federal securities class action lawsuits filed in the U.S. District Court for the Southern District of New York (the “District Court”). The cases allege violations of various securities laws by more than 300 issuers of stock, including us, and the underwriters for such issuers, on behalf of a class of plaintiffs who, in our case, purchased our stock between September 21, 1999 and December 6, 2000 in connection with our initial public offering. Specifically, the complaints allege that the underwriter defendants engaged in a scheme concerning sales of our and other issuers’ securities in the initial public offering and in the aftermarket. In July 2003, we decided to join a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. In April 2005, the court requested a modification to the original settlement arrangement which was approved by us. Although we believed that the plaintiffs’ claims had no merit, we had decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. We were a party to a global settlement with the plaintiffs that would have disposed of all claims against it with no admission of wrongdoing by us or any of its present or former officers or directors. The settlement agreement had been preliminarily approved by the District Court. However, while the settlement was awaiting final approval by the District Court, in December 2006, the Court of Appeals reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Court of Appeals denied the plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the District Court approved a stipulation withdrawing the proposed settlement. On August 14, 2007, the plaintiffs filed an amended complaint in the six focus cases to test the sufficiency of their class allegations. On September 27, 2007, the plaintiffs filed a motion for class certification in the six focus cases, which the District Court has not yet decided. On November 13, 2007, the defendants filed a motion to dismiss the complaint for failure to state a claim, which the District Court denied on March 8, 2008. We believe we have meritorious defenses to these claims and intend to defend against this action vigorously. In addition, in October 2007, a lawsuit was filed in the U.S. District Court for the Western District of Washington by Ms. Vanessa Simmonds against certain of the underwriters of our initial public offering. The plaintiff alleges that the underwriters violated Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. section 78p(b), by engaging in short-swing trades, and seeks disgorgement of profits from the underwriters in amounts to be proven at trial. On February 25, 2008, Ms. Simmonds filed an amended complaint. The suit names us as a nominal defendant, contains no claims against us, and seeks no relief from us.

Other third parties have from time to time claimed, and others may claim in the future that we have infringed their past, current or future intellectual property rights. We have in the past been forced to litigate such claims. These claims, whether meritorious or not, could be time-consuming, result in costly litigation, require expensive changes in our methods of doing business or could require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business.

The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact on our results of operations, consolidated balance sheets and cash flows due to defense costs, and divert management resources.

 

ITEM 1A. RISK FACTORS.

Information regarding the Company’s risk factors appears in “Part I. Financial Information — Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Quarterly Report on Form 10-Q and in “Part I. – Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

Not applicable.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

Not applicable.

 

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not applicable.

 

ITEM 5. OTHER INFORMATION.

Not applicable.

 

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ITEM 6. EXHIBITS

 

         

Incorporated by Reference

    

Exhibit
Number

  

Exhibit Description

  

Form

  

File No.

  

Exhibit

  

Filing

Date

  

Provided

Herewith

31.01    Certification of Principal Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.                X
31.02    Certification of Principal Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.                X
32.01    Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                X
32.02    Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                X

 

* These certifications accompany KANA’s Quarterly Report on Form 10-Q; they are not deemed “filed” with the Securities and Exchange Commission and are not to be incorporated by reference in any filing of KANA under the Securities Act of 1933, or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

August 11, 2008

 

Kana Software, Inc.
/s/ Michael S. Fields

Michael S. Fields

Chairman of the Board of Directors and Chief Executive Officer

(Principal Executive Officer)

/s/ Michael J. Shannahan

Michael J. Shannahan

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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Exhibit Index

 

         

Incorporated by Reference

    

Exhibit
Number

  

Exhibit Description

  

Form

  

File No.

  

Exhibit

  

Filing

Date

  

Provided

Herewith

31.01    Certification of Principal Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.                X
31.02    Certification of Principal Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.                X
32.01    Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                X
32.02    Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*                X

 

* These certifications accompany KANA’s Quarterly Report on Form 10-Q; they are not deemed “filed” with the Securities and Exchange Commission and are not to be incorporated by reference in any filing of KANA under the Securities Act of 1933, or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.

 

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